What is Amortization and How is It Calculated?
Amortization is a process used to allocate the cost of an asset over the course of its useful life. It involves dividing the cost of the asset into periodic payments, such as monthly or yearly, to eventually capture the entire value of the asset. This type of repayment plan is used by businesses and individuals alike to finance large purchases, such as cars and expensive equipment. In this article, we’ll discuss what amortization is, how it works, and how it’s calculated.
What is Amortization?
Amortization is the process of gradually expensing an intangible asset or a loan over the course of its useful life. It is the gradual decrease in the value of an asset or loan due to periodic payments made towards and interest rates associated with the borrowing of money. This process ensures that a person or business has the funds to make repayments on time, and in full.
In finance, amortization is most commonly used to refer to the repayment of debt over time, as well as the increasing cost of a loan with additional fees and interest. This type of repayment schedule can also be used for intangible assets such as patents, copyrights, and trademarks, which have a limited useful life.
When an amortization schedule is used, the borrower pays back the loan amount with both principal and interest payments. This means that each payment reduces the amount of debt owed, but at a higher rate of interest than the original loan amount. The repayment schedule can be made in either fixed or variable amounts, and they can also be paid on a regular, monthly or yearly basis.
How Does Amortization Work?
Amortization works in that it allocates the cost of an asset or loan over its useful life. This means that the cost of the asset or loan is spread out over a set period of time and paid back as a series of payments, typically with both principal and interest. The payments are divided into equal installments and each payment is for both principal and interest.
When amortizing a loan, the periodic payment amount stays the same throughout the life of the loan, however, the principal and the interest paid in each payment changes over time. As the loan balance decreases, the portion of each payment applied to the principal increases.
How to Calculate Amortization
Calculating an amortization loan is relatively straightforward. It involves a few simple calculations to determine how much of each payment is applied to the principal and interest. The following formula is commonly used to calculate an amortization schedule:
“Formula = Payment Amount × [ i / 1 –(1+i ) ^ –n ]
Where:
Payment Amount = Total due for each payment
i = annual interest rate
n = total number of payments
For example, let’s say you take out a $10,000 loan with a 6 percent interest rate. The total number of payments on the loan is 48 months, with monthly payments of $224.30. After 48 months, you’d have paid back a total of $10,758.08.
Using the formula, we can calculate how much of each payment goes towards the principal balance each month. For month 1, the principal portion of your payment is $203.73, and the interest is $20.58. For month 2, the principle portion rises to $207.07, while the interest drops to $17.25.
Amortization can be a crucial part of any long-term loan or asset purchase. It helps individuals and businesses plan for the long-term costs of a major purchase and ensures a manageable repayment schedule. With a little bit of calculation, individuals and businesses can ensure that they are taking full advantage of their amortization loans.
