Amortization is a financial concept in the world of loans, assets, and investing. It essentially spreads the cost or value of something over time. With loans, it’s spreading repayment over time. With assets, it’s spreading the cost of the asset over time. Let’s explore amortization and how it’s used, some types, and how it differs from depreciation.
Here’s what we’re going to cover:
- Definition
- Types of amortization
- How to calculate
- Example of amortization
- Amortization vs. depreciation
- Oportun: Affordable lending options designed with you in mind
Key takeaways
- Amortization spreads out loan repayment into fixed, periodic payments of principal and interest.
- Amortization can also be used for intangible assets and investments.
- You can calculate amortization with the amortization formula or use a calculator.
- Amortization and depreciation are similar, but depreciation slowly reduces a tangible asset’s value (something you can touch and feel, like a house or car).
Definition
Amortization is a loan repayment structure that entails scheduled, periodic, equal payments applied to the loan’s principal and interest. It involves adding a loan’s total
interest to its total principal, and then breaking the sum into equal payments over the loan repayment period. Installment loans are typically amortized loans.
Why is amortization important?
Amortization helps individuals and businesses spread large debts, such as mortgages or personal loans, over a long period. This allows them to pay the loan in fixed payments that fit their budgets, making the large cost of the item more attainable.
Furthermore, amortization makes financial planning and decision-making easier. The borrower knows how much the loan will cost them each month, making it easier to predict their future costs and allocate their funds properly.
Types of amortization
Here are several types of amortization and how they work:
Loan amortization
Loan amortization is a common type of amortization. As mentioned above, it involves breaking a loan into fixed, equal payments of principal and interest over a defined timeframe. This payment structure gradually reduces the principal balance.
As the principal balance decreases, there is less principal on which to charge interest. This reduces the monthly interest charge. Each subsequent payment applies to a larger portion of the principal balance.
Amortization of intangible assets
Companies also use amortization to gradually reduce the value of intangible (non-physical) business assets, like copyrights and patents. These assets lose value more abstractly than tangible assets, such as equipment. So, amortization is used to estimate that loss in value.
Amortization and investing
Certain investments are amortized, such as bonds. Governments and corporations sell debt securities as bonds when they need to raise money. When you buy a bond, the government or corporation gets the funds up front, and repays it to you over time with interest until it’s repaid in full. The bond is amortized.
How to calculate
Use an amortization calculator online. You can enter each number into the correct box, and the calculator will create an amortization schedule.
This is the formula for calculating loan amortization:
A = P x [ { r(1+r)n } / { (1+r)n – 1 } ]
- A is the periodic loan payment
- P is the total principal balance
- r is the periodic interest rate
- n is the total number of payments
To determine the split between principal and interest in a month, multiply your principal balance by your annual interest rate. Then, divide that by 12 months to get your current month’s interest fee. Subtract that interest fee from the total monthly payment amount to get your monthly principal payment.
Example of amortization
Imagine you get a 30-year fixed-rate $100,000 mortgage at 4% annual interest. Payments are due monthly, meaning you will have 360 total payment periods (30 x 12), and your monthly interest rate will be 0.33% (4% / 12).
- P = $100,000
- r = 0.33333%, or 0.0033333 (about ⅓ of 1%)
- n = 360
A = P x [ { r(1+r)n } / { (1+r)n – 1 } ]
A = $100,000 x [ {0.0033333(1+0.0033)360 } / { (1+0.0033333)360 – 1 } ]
A = $477.42
Your monthly mortgage payment is $477.42. To calculate the first month, multiply your $100,000 principal balance by the 4% annual interest rate, or 0.04, to get $4,000. Divide this by 12 months to get $333.33. So, your interest amount is $333.33. Subtract $333.33 from $477.42 to get a principal payment of $144.09. Since your principal decreases after the first payment, each subsequent payment will have a smaller interest portion and a larger principal portion.
Amortization vs. depreciation
Amortization and depreciation are similar in that they spread out the decline in the value of products over time in a predictable fashion. Amortization is for non-physical items, for example, a loan balance gets smaller as it’s paid off. Depreciation is for physical items, like how a car uses value as it’s driven.
Oportun: Affordable lending options designed with you in mind
Now that you understand what amortization is, you can learn about how Oportun may be able to help you if you’re looking for affordable credit options. Visit our homepage to learn about:
- Personal loans
- Secured personal loans
- Savings
- And more!
Sources
Investopedia. What is an Amortization Schedule? How to Calculate with Formula
Ramsey Solutions. What is an Amortization Schedule and How Does It Work?
Investopedia. Amortization vs. Depreciation: What’s the Difference?
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