Amortization

Amortization is an accounting technique used to periodically lower the book value of a loan or an intangible asset over a set period of time. In relation to a loan, amortization focuses on spreading out loan payments over time. When applied to an asset, amortization is similar to depreciation.

Amortization refers to the process of paying off a debt through scheduled, pre-determined instalments that include principal and interest. In almost every area where the term amortization is applicable, the payments are made in the form of principal and interest.

Such usage of the term relates to debt or loans, but it is also used in the process of periodically lowering the value of intangible assets much like the concept of depreciation.

The term “amortization” refers to two situations. First, amortization is used in the process of paying off debt through regular principal and interest payments over time. An amortization schedule is used to reduce the current balance on a loan for example, a mortgage or a car loan through installment payments.

Second, amortization can also refer to the spreading out of capital expenses related to intangible assets over a specific duration usually over the asset’s useful life for accounting and tax purposes.

In business, amortization refers to spreading payments over multiple periods. The term is used for two separate processes: amortization of loans and amortization of assets.

Amortization of Assets

Amortization means something different when dealing with assets, specifically intangible assets, which are not physical, such as branding, intellectual property, and trademarks. In this setting, amortization is the periodic reduction in value over time, similar to depreciation of fixed assets.

Amortization of a Loan

The amortization of a loan is the process to pay back, in full, over time the outstanding balance. In most cases, when a loan is given, a series of fixed payments is established at the outset, and the individual who receives the loan is responsible for meeting each of the payments.

Applications of amortization

• When used in the context of a home purchase, amortization is the process by which loan principal decreases over the life of a loan, typically an amortizing loan. As each mortgage payment is made, part of the payment is applied as interest on the loan, and the remainder of the payment is applied towards reducing the principal. An amortization schedule, a table detailing each periodic payment on a loan, shows the amounts of principal and interest and demonstrates how a loan’s principal amount decreases over time. An amortization schedule can be generated by an amortization calculator. Negative amortization is an amortization schedule where the loan amount actually increases through not paying the full interest.
• In business, amortization allocates a lump sum amount to different time periods, particularly for loans and other forms of finance, including related interest or other finance charges. Amortization is also applied to capital expenditures of certain assets under accounting rules, particularly intangible assets, in a manner analogous to depreciation.
• In tax law in the United States, amortization refers to the cost recovery system for intangible property.
• In computer science, amortized analysis is a method of analyzing the execution cost of algorithms over a sequence of operations.
• In the context of zoning regulations, amortization refers to the time period a non-conforming property has to conform to a new zoning classification before the non-conforming use becomes prohibited. For example, if the city rezones property from industrial to residential and sets an amortization period of one year, all property within the rezoned boundary must move from industrial use to residential use within one year.
• In the context of Securitization the Joshua Curve relates to a unique amortization profile that results in the innovative “horseshoe Shape” or “J Shape” weighted average life (“WAL”) distribution. In other words, if the base case results in a WAL of 10.0 years, the stress case and performance case would both result in reduced WALs that are both less than 10.0 years due to accelerated amortization.

Amortization Calculation

The formula to calculate the monthly principal due on an amortized loan is as follows:

Principal Payment = Total Monthly Payment – (Outstanding Loan Balance × (Interest Rate/12 Months))

Typically, the total monthly payment is specified when you take out a loan. However, if you are attempting to estimate or compare monthly payments based on a given set of factors, such as loan amount and interest rate, then you may need to calculate the monthly payment as well. If you need to calculate the total monthly payment for any reason, the formula is as follows:

Total Monthly Payment = Loan Amount [ i (1+i) ÷ n / ((1+i) ÷ n) – 1) ]

Where:

i = monthly interest rate: You’ll need to divide your annual interest rate by 12. For example, if your annual interest rate is 3%, then your monthly interest rate will be 0.0025% (0.03 annual interest rate ÷ 12 months).

n = number of payments over the loan’s lifetime: You multiply the number of years in your loan term by 12. For example, a four-year car loan would have 48 payments (four years × 12 months).

Accounting for Amortization

The journal entry to record amortization for an intangible asset is:

If an intangible asset has an unlimited life, then it is still subject to a periodic impairment test, which may result in a reduction of its book value.