In essence, it is a method of spreading out the cost of a large purchase or loan over the course of several years.
What is Amortization?
To understand what amortization is and how it works, it is important to first understand the concept of a loan. A loan is a sum of money borrowed from a lender that must be paid back with interest over a certain period of time. When a borrower takes out a loan, they agree to a repayment schedule that outlines the amount of money they will pay back each month until the loan is fully paid off.
In the case of an amortized loan, the borrower pays back the loan in equal installments over a set period of time. Each payment is split between the principal (the amount of the loan) and the interest (the cost of borrowing the money). Initially, a larger portion of the payment goes toward the interest, but as time goes on, more of the payment goes toward the principal.
For example, let's say you took out a $10,000 loan with a 5% interest rate and a 5-year repayment term. Using an amortization calculator, your monthly payment would be $188.71. In the first month, $41.67 of that payment would go toward interest and $147.04 would go toward the principal. In the final month of the loan, the entire payment would go toward the principal.
Amortization is an important concept to understand because it can affect your finances in a number of ways. For one, it can impact your cash flow. Since you are making the same payment each month, you can budget for it and plan accordingly. It can also impact the total amount of interest you pay over the life of the loan. Because you are paying down the principal over time, you will pay less interest over the life of the loan than you would with a loan that does not amortize.
Amortization is used for a variety of different types of loans, including mortgages, car loans, and personal loans. It is also used in accounting to refer to the process of spreading out the cost of an asset over its useful life. In this context, it is used to calculate the depreciation expense of an asset.
Amortization vs Depreciation
Depreciation and amortization are both terms used in accounting to describe the process of spreading out the cost of an asset over its useful life. While the two terms are similar in many ways, there are some key differences between them.
Depreciation is used to describe the process of spreading out the cost of a tangible asset over its useful life. Tangible assets include things like buildings, equipment, and vehicles. Depreciation is used to account for the fact that these assets lose value over time and eventually become obsolete or need to be replaced. The process of depreciation allows businesses to spread out the cost of the asset over its useful life, reducing the impact of the initial cost on the company's financial statements.
Amortization, on the other hand, is used to describe the process of spreading out the cost of an intangible asset over its useful life. Intangible assets include things like patents, copyrights, and trademarks. These assets are valuable to a business because they give the company a competitive advantage, but they do not have a physical form. Amortization allows businesses to account for the cost of these assets over time, reducing the impact on the company's financial statements.
One key difference between depreciation and amortization is the type of asset being accounted for. Depreciation is used for tangible assets, while amortization is used for intangible assets. Additionally, the methods used to calculate depreciation and amortization can be different.
For example, there are several methods for calculating depreciation, including straight-line depreciation and accelerated depreciation. Straight-line depreciation spreads the cost of the asset evenly over its useful life, while accelerated depreciation front-loads the depreciation expense. The method used depends on the specific asset and the company's accounting policies.
Similarly, there are several methods for calculating amortization, including straight-line amortization and declining balance amortization. Straight-line amortization spreads the cost of the asset evenly over its useful life, while declining balance amortization front-loads the expense.
Another key difference between depreciation and amortization is the length of time over which the cost of the asset is spread out. Depreciation is typically calculated over a longer period of time than amortization. For example, the useful life of a building might be 30 years, while the useful life of a patent might be only 10 years.
Credit can come in many forms, such as credit cards, loans, mortgages, and lines of credit. Each of these has its unique features, but they all involve borrowing funds with the expectation of repaying them over time.
For example, when a person takes out a loan, they may use their property or real estate as collateral for the loan.