The financial industry has no shortage of specialized vocabulary. But things get even more confusing when a financial term has multiple definitions, depending on the audience it’s intended for.
Such is the case with “amortization.”
In general, amortization is the process of allocating a fixed, lump sum payment over multiple payment periods. However, this term can be tricky because it can apply to two different audiences: businesses and individual borrowers.
In the first instance, amortization is used by businesses looking to expense intangible assets that they will use over a long time. However, amortization is also commonly used by borrowers to determine how much of their monthly payments are applied to the interest and the principal of their loan, respectively.
Here’s a breakdown of how amortization works in each of these scenarios.
How Does Amortization Work for Businesses Expensing Assets?
Businesses often use amortization to account for the cost of intangible, or non-physical, assets over their useful life. Amortization is similar to depreciation, which is used for physical assets, to show how value decreases over time. Some intangible assets that may require amortization include trademarks, patents, customer lists, franchise agreements, and computer software.
For example, let’s say a business spends $20,000 for a ten-year patent, which will have no economic value when it expires. The business can allocate $2,000 per year as an amortization expense toward the patent’s cost for accounting purposes. The benefit here is that amortization more clearly helps businesses align how much an asset costs with the revenue it helps to generate during its useful life.
A notable exception is that businesses should not amortize expenses for intangible assets that will still provide economic value indefinitely or without deterioration over time.
How Does Amortization Work for Borrowers Paying Off Their Loans?
On the flip side, amortization can also be applied to individual borrowers paying off their debt.
In this case, amortization refers to how much of a monthly payment (often called an “installment” for large purchases like mortgages or auto loans) is allocated toward the interest and principal of a loan. More specifically, an amortization schedule visualizes how much of the monthly payment goes toward the interest on a loan, and how much goes to the principal over time.
Let’s look at an example with a mortgage. Borrowers who take out a mortgage will have a fixed monthly payment, which will remain the same throughout the duration of the loan. However, the amount of the monthly payment that is allocated toward interest and toward the principal will change over time.
When the borrower first starts paying off a mortgage loan, a high percentage of the payment will go toward paying off the interest and a smaller percentage will be applied toward the principal. As time goes on, the situation becomes reversed, with more of the payment being applied to the principal and less toward the interest.
Borrowers should receive an amortization schedule from the lender upon taking out a mortgage or loan. If you want to see an example of how amortization might work based on different interest rates and time periods, there are plenty of online calculators to help you create an amortization schedule.
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