What is Amortization?

amortizationAmortization is an accounting term that refers to the process of allocating the cost of an intangible asset over a period of time. It also refers to the repayment of loan principal over time.

Amortization is an accounting technique used to lower the cost value of a finite life or intangible asset incrementally through scheduled charges to income. Amortization is the paying off of debt with a fixed repayment schedule in regular installments over time like with a mortgage or a car loan. It also refers to the spreading out of capital expenses for intangible assets over a specific duration, usually over the asset’s useful life, for accounting and tax purposes.

Amortization can refer to the paying off of debt, over time, in regular installments of interest and principal adequate enough to repay the loan in full by maturity. Amortization can also mean the deduction of capital expenses over the asset’s useful life where it measures the consumption of an intangible asset’s value, such as goodwill, a patent or copyright.

Amortization is like depreciation, which is used for tangible assets, and depletion, which is used for natural resources. When businesses amortize expenses, it helps tie the asset’s costs to the revenues it generates. For example, if a company buys a ream of paper, it writes off the cost in the year of purchase and generally uses all the paper the same year. Conversely, with a large asset, the business reaps the rewards of the expense for years. Thus, it writes off the expense incrementally over the useful life of that asset, tangible or intangible.

Negative Amortization

Negative amortization (also called deferred interest) occurs if the payments made do not cover the interest due. The remaining interest owed is added to the outstanding loan balance, making it larger than the original loan amount.

If the repayment model for a loan is fully amortized, then the very last payment (which, if the schedule was calculated correctly, should be equal to all others) pays off all remaining principal and interest on the loan. If the repayment model on a loan is not fully amortized, then the last payment due may be a large balloon payment of all remaining principal and interest. If the borrower lacks the funds or assets to immediately make that payment, or adequate credit to refinance the balance into a new loan, the borrower may end up in default.

Business

In business, amortization refers to spreading payments over multiple periods. The term is used for two separate processes: amortization of loans and amortization of assets. In the latter case it refers to allocating the cost of an intangible asset over a period of time.

Loans

With auto and home loan payments, most of the monthly payment goes toward interest early in the loan. With each subsequent payment, a greater percentage of the payment goes toward the loan’s principal. For example, on a five-year $20,000 auto loan at 6 percent interest, $286.66 of the first $386.66 monthly payment goes to principal while $100 goes to interest. In the last monthly payment, $384.73 goes to principal and $1.92 goes to interest. Mortgage amortization works a similar way.

Tax

The Internal Revenue Service allows taxpayers to take a deduction for certain amortized expenses: geological and geophysical expenses incurred in oil and natural gas exploration, atmospheric pollution control facilities, bond premiums, research and development, lease acquisition, forestation and reforestation, and certain intangibles such as goodwill, patents, copyrights and trademarks. One can calculate amortization using most modern financial calculators, spreadsheet software packages such as Microsoft Excel, or amortization charts and tables.

To deduct amortization costs, the IRS requires tax filers to complete Part VI of Form 4562. The IRS has schedules dictating which percentage of an asset’s cost a business should amortize each year. These schedules break intangible assets into categories with slightly different amortization rates.

 


 

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