What is amortization?
Amortization is a way to reduce the value of something over time slowly. This “something” could be money that a person or company owes, which is called a liability, or something valuable that a person or company owns, which is called an asset.
The word “amortization” sounds fancy, but it just means spreading the value reduction over time instead of doing it all at once. Think of it like eating a big meal in small bites rather than swallowing it whole.
Amortization of loans
One common type of amortization is for loans. Let’s say you borrow $100 from the bank to buy something. The bank will probably make you pay them back a little bit each month rather than paying the whole $100 back at once. Each of those little monthly payments reduces the amount you owe. So your loan balance goes down bit by bit, month after month. That’s amortization.
When you pay on an amortizing loan, part of the money goes to paying interest, and part goes to reducing the loan balance (the principal). In the beginning, more of your payment goes to interest. But over time, more and more of each payment goes to the principal, so you pay down what you owe faster and faster.
The exact amount you pay each month is laid out in something called an amortization schedule. This schedule shows how your payments are split between interest and principal over the life of the loan. The schedule is set up when you first get the loan and usually doesn’t change.
Different loans can have different amortization schedules. Yours might require you to pay the same amount monthly for the whole loan. Or your payments might start low and get bigger over time. There are lots of possibilities. The main thing is that amortization means spreading out the payback over time.
Amortization of assets
The other primary type of amortization concerns assets. An asset is something valuable that a person or company owns. Some assets, like buildings or equipment, lose value as they age and become more used.
Let’s say a bakery buys an oven for $10,000. That oven is an asset because it helps the bakery make money by baking bread, cookies, and cakes to sell. But the stove won’t last forever. As the years go by, it will wear out, break down more, and eventually need to be replaced.
From an accounting perspective, the oven’s value is going down. It might have been worth the entire $10,000 when it was brand new, but after a year of heavy use, it’s not worth much anymore. And next year, it will be worth even less.
The bakery can recognize this slow loss in value through amortization. Each year, they record a bit of the oven’s value as an expense to show it has gone down. This expense is called depreciation for a physical asset like an oven.
The amount of depreciation the bakery records each year is based on accounting rules. Different types of assets have different rules. The rules try to approximate how quickly that type of asset usually wears out and loses its value.
Like loan payments, the bakery will have a schedule showing how much the oven depreciates over the years. This has helped the bakery spread oven costs over the years, and the stove has assisted the bakery in making money.
Why is amortization necessary?
Amortization is essential for a few key reasons:
Tracking business performance
Businesses need to keep good financial records to track their performance. Amortization is a vital part of this.
For one thing, it helps businesses spread the cost of significant expenses. Imagine if the bakery had to count the entire $10,000 for the oven as an expense in the year they bought it. Their financial records for that year would look terrible!
By amortizing the cost of the oven over its useful life, the bakery’s expenses are more aligned with its revenues each year. The years when the oven works hard to bake lots of goodies will show the depreciation expense, not just the year when the stove was purchased.
Amortization of loans works similarly from the lender’s perspective. The lender records the interest they receive as revenue over time as earned, not all at once when the loan is made.
Making strategic decisions
Having good records with proper amortization also helps businesses make strategic decisions. The bakery owner can look at her financial statements and see that the oven is getting old and might need to be replaced soon. Knowing that significant expense is coming, she might decide to start saving up for a new oven or to put off expanding to a second location.
Tax and regulatory compliance
Tax laws and accounting regulations require many businesses to track amortization and depreciation properly. The specific rules can be complex and may vary for different types of assets, companies, or locations.
Usually, a business can deduct loan interest and asset depreciation from its taxable income each year. How these expenses are amortized can affect the amount of tax the company owes.
Correct and complete books are also important for securing loans, attracting investors, or even being acquired, especially for large businesses. If the bakery owner wanted to sell her business, potential buyers would look very carefully at how she had been tracking her assets and liabilities.
How does amortization work in personal finance?
While businesses use amortization for both loans and assets, it most commonly comes up with loans for individuals for individuals. If you’ve ever had a car loan or a mortgage on your home, you’ve probably dealt with amortization.
Home mortgages
Most people’s mortgage is amortized over a long period, often 30 years. The borrower pays a set amount each month, and over time, more of each payment goes towards paying down the loan principal rather than just covering interest.
Most of each payment is interest in the early years of a 30-year mortgage. The borrower is barely chipping away at the actual loan balance. But as the years go by, the split starts to shift. By the end of the loan, the payments are almost all principal, and the loan gets paid off rapidly.
This is why making extra mortgage payments can save so much money in the long run. Every additional bit you pay goes directly to the loan balance, so there’s less principal accruing interest for the rest of the loan term. Paying a mortgage off early can easily save tens of thousands in interest.
Car loans
Car loans are usually amortized over a much shorter period than mortgages, often just a few years. The basic principle is the same – part of each payment goes to interest and part to principal, with the split shifting over time.
However, car loans are often “upside down” in the early years, meaning the borrower owes more than the car is worth. This is because cars depreciate very quickly when they’re brand new. The loan amortization schedule doesn’t keep pace with how fast the car loses value.
This can cause problems if the borrower needs to sell the car early in the loan term. They may not get enough from the sale to pay off the remaining loan balance, and longer car loan terms can make this even more likely.
Student loans
Student loans, whether federal or private, also involve amortization. Often, students don’t have to start repaying until after they graduate. However, once repayment begins, the loans are amortized over a set term, usually 10 years for federal loans.
Like other loans, amortization means more of each payment initially goes to interest. Borrowers who can pay more than the minimum required payment can pay the loans off faster and save a lot on interest.
Some student loans, like federal income-driven repayment plans, may have different amortization schedules. Payments may start very low and increase as the borrower’s income rises, making the loan take longer.
Final Overview
Amortization is all about spreading things out over time. Whether it’s the cost of a significant purchase or the payback of a loan, amortization is a way to parse it into smaller chunks.
Amortization is vital for businesses to track financial performance, make big decisions, and comply with accounting rules. Understanding how loans are amortized can help individuals make smart choices about their debt.
The next time you hear the word amortization, don’t be intimidated. It’s just a fancy saying,yi, “Let’s take this bit by bit.”
