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What is Amortization?
Amortization is the accounting process by which the value of a loan or an intangible asset sees its value recording lower as time passes. You often hear about depreciation in the finance world, but amortization sees a lot of confusion for anyone without an accounting degree. So what is the difference and why is amortization so important? Amortization focuses on assets or loans that exist on paper but are intangible. Here, we will dig deeper into the concept of amortization to help explain its use, purpose, and differences between other common financial tools.
The Definition of Amortization
The term amortization serves two purposes in the accounting world. For that, there are two definitions you need to understand in total. All-in, amortization will do the same thing across both platforms, but the way it works differs slightly.
The first scenario where amortization comes into play is with the intangible asset factor. If you have capital expenses you pay over time towards an intangible asset, the asset will have a useful life put to it. The most common example of an intangible asset is something like a website or a piece of software. As a company, you pay capital to create it, but in the end, you cannot physically hold it. The capital you pay becomes the total you amortize or spread out amortization of, over the useful life of the asset.
The second scenario for amortization has to do with loans. When you have a loan and you are paying off debt with principal and interest payments, the amortization schedule will show the reduction of the balance. A car loan or a home loan are two of the most common examples of when you would get a formal amortization schedule. As you pay your car loan, a portion goes to the principal and the rest interest. The schedule shows the reduction of the loan over time.
How Amortization Works
Amortization is all about calculating value over time. In the situation of amortization expense, as it relates to intangible assets, it starts with the useful life of an asset. As you build a piece of software, you are sending on development costs, training, testing, and more. All this needs tracking so it can see added to the overall cost of the intangible asset. You total it and capitalize the intangible asset on your balance sheet when substantial testing is complete to the point where the software is ready for use. From there, you determine the useful life of the software, usually on a straight-line basis. For software, this is typically 15-years.
So now say on January 1 you put a $150,000 piece of software into production and add it to your balance sheet. On January 1 of the following year, one year of useful life is gone. You recognize that as a $10,000 amortization expense on your profit and loss for the year, and the value of the intangible asset drops to $140,000 accordingly. This keeps happening until the asset has a value of $0.
Amortization calculations for loans work a bit differently, but with the same concept. Amortization for a loan begins with the outstanding loan balance each month. When a loan first starts, a monthly payment calculation takes place. The interest rate sees calculation against the outstanding loan balance, divided by 12 months. The principal is the amount due, the total for the month, minus that interest payment, and does not change over time.
As the months and years go by, the outstanding loan balance changes as the principal cost brings the balance down. The payment you make does not change, but what happens is the amount of principal you pay over time goes up, while the interest goes down. This is because the interest payment sees calculation over the most recent balance. This is why your mortgage payment will not change, but the principal you pay to the loan continues to increase monthly.
Types of Amortizing Loans
The most common type of amortizing loan is that of an installment loan. Installment loans are loans you pay periodically, usually monthly, until the balance of the loan gets to $0. The common installment loans out there include home equity loans, auto loans, and mortgages or home loans.
Benefits and Drawbacks of Amortization
There are a lot of benefits and drawbacks when it comes to amortization. On the benefits side of the house, whether you are a business with an intangible asset or taking out an installment loan, it gives you the ability to recognize and pay properly over time. Without amortization, interest may not calculate accurately over the life of a loan. The ease of that simple monthly payment is made possible due to the amortization schedule and amortization concepts in place. With intangible assets, it allows you to recognize the true value of the asset on your balance sheet and expense what you in theory put to use in that year.
The disadvantage of amortization is minimal. You may want to try and lower your monthly payment over time, but with amortization, you cannot as the payment remains fixed while the interest and principal change. For a business, amortization does not allow you to expense the entire cost of building a piece of software or similar asset in the year it is put in use (unless you do a special tax election), thus the expense may drag over time.
What Assets Are Amortized?
The most common types of assets you see amortized include:
- Lease Rental
What is the Difference Between Depreciation and Amortization?
Depreciation and amortization are similar in their application. The big difference is that depreciation deals with a tangible asset, such as a house or a car, while amortization deals with an intangible asset, such as the software the company built to install in all their cars.
What is the Difference Between Capitalization and Amortization?
Capitalization is the amount you recognize as the value of the asset. In short, capitalization is the start of the process to amortize, so they work together but are very different. When you finish filing a trademark, all the costs that went into that go into the capitalized amount. The amortization period begins from the start of that useful life point.
Frequently Asked Questions on Amortization
What Does an Amortization Schedule Look Like?
A common amortization schedule will look just like a chart where you have one row along the top with headers, with the data underneath. The schedule or chart will show how your payment sees distribution over time. You will see the month, the payment, the balance, and how much principal as well as interest you pay monthly with that basis in mind.
What is Reverse Amortization and Could It Help?
Reverse amortization works differently than standard amortization. As the name implies, it works in the opposite direction. Say you are buying a home and you want to start with a low payment, the reverse amortization process works where you pay the smaller amount of interest out of the gate, thus your payment is lower. As time goes by, your payment goes up. This works for many individuals as, in theory, income will increase over time.
Amortization is unique in its application but can provide a lot of benefits to individuals and businesses. Whether you are applying amortization to intangible assets or to an installment loan, understanding how it works can provide you with financial understanding and the positives it brings with it. Source Capital is your resource to help you meet your capital needs to make that next big financial move!