The world of accounting is a labyrinth of numbers, formulas and calculations, with the aim of bringing order and balance between assets and liabilities.
One term that defines the intricacies of complex bookkeeping is depreciation, the Swiss Army Knife in an accountant’s toolbox.
Businesses and individuals can take advantage of depreciation to depreciate assets over the expected period of asset use and create faster ways to pay off installment loans – steps that can translate into a big financial benefit.
What is depreciation?
Amortization covers two definitions – one focused on business assets and the other focused on loan repayments.
What is depreciation for businesses?
Depreciation is an accounting tool that essentially directs assets from a balance sheet to an income statement. It does this by writing off the assets (mainly intangible) over their period of intended use. These assets can include copyrights, patents and trademarks.
Let’s say a company has a valuable patent, which has been active for 10 years. If the company paid $ 10 million to develop the patent, it would write $ 1 million each year as a depreciation expense and report it in the company’s income statement.
What is loan amortization?
Consumers may best recognize amortization as a term that describes the breakdown of a loan’s starting balance, less principal and interest owed over a period of time, such as a mortgage or car loan. On these loans, the amortization schedule weighs much more heavily on the interest payments on a loan at the start of the loan repayment period, with that interest decreasing throughout the life of the loan.
Let’s say a wealthy person has a $ 1 million mortgage. If that person repays $ 50,000 on an annual basis, then the borrower has amortized $ 50,000 of the loan each year.
For the purposes of this article, we’ll look at the impact of amortization on loans, specifically how it refers to the repayment of loan principal over time.
How does amortization work for loans?
Basically, amortization is a mechanism to pay off both principal and interest on a loan, bundled into one fixed monthly payment. Lenders calculate amortization down to the penny, so that the loan is repaid accurately, over the agreed period of time. (Accountants call this period the “term” of the loan.)
This way, each loan payment is exactly the same amount of money. Consider a mortgage of $ 165,000 over 30 years, with an interest rate of 4.5%. Since amortization refers to the repayment period of a loan, with a specific amount allocated to pay principal and interest, the amortization schedule is a total fixed monthly payment of $ 836.03 over the term of the loan. mortgage.
On a monthly basis, over 30 years, this is what is needed in terms of actual monthly payments to fully repay the mortgage.
How to calculate the amortization of a loan
Since amortization is the process of paying the same amount of money (usually) on a monthly basis, the calculation to do so depends on the principal and interest owed on the loan. The goal is to lower the interest payments over the life of the loan, while the principal amount of the loan increases.
Here’s how to do it step by step:
Collect all the loan information needed to calculate the loan amortization schedule. Basically all you need is the term of the loan and the payment terms. Let’s calculate the amortization rate on a monthly basis, like most mortgage or auto loans.
- Find the main part of the current loan (say $ 100,000.)
- Find the interest rate on the loan (say 6%).
- Find the length of the loan (say 360 months, or 30 years.)
- Monthly payment = $ 599.55
Although the actual loan amount is fixed, the amount you pay on a loan in terms of principal and interest is not. This is where a loan amortization schedule comes into play.
To correctly calculate amortization and find the correct balance between principal and interest payments, multiply the original loan balance by the periodic loan interest rate. The resulting figure will be the amount of interest due on a monthly payment. At this point, you can subtract the interest payment amount from the total loan amount to establish the portion of the loan required to repay the principal.
Suppose, for example, you have a mortgage loan of $ 240,000, for 360 months, at an interest rate of 4%. Your initial monthly mortgage payment is $ 1,146. Your periodic interest rate is 0.33%, or one twelfth of 4%.
Multiply $ 240,000 by 0.33% and you will find that the first interest rate payment on the mortgage is $ 792. Now take the total monthly loan of $ 1,146 and subtract the interest amount of $ 792.00. This leaves you with $ 354 as the monthly loan repayment amount which will go toward the principal owed on the loan.
To calculate your amortization rate in the future, take the remaining principal balance of the loan ($ 240,000 minus $ 354 = $ 239,646.) Then multiply $ 239,646 by 0.33% to determine the amount of your next interest payment. Simply repeat the calculation to determine the amortization schedules down the line on a monthly basis.
What types of loans can be amortized?
Typically, amortization schedules are used for the following loans – usually installment loans:
Loans that cannot be amortized include home equity loans, revolving debt, and credit cards, as these types of credit-based loans do not have fixed monthly payments.
Revolving debt and credit cards do not have the same characteristics as an amortized loan because they do not have a fixed payment amount or a fixed loan amount.
Basically, if your lender tells you exactly how many payments you need to make to honor the loan and tells you that each monthly payment will be the same amount, it can be amortized. If the total loan amount varies from month to month, it is likely that it cannot be amortized.
Advice on loan amortization
To pay off your amortized loans faster and get rid of the loan completely, incorporate these strategies into your loan repayment plan:
- Add extra dollars to your monthly payment. If your total mortgage is $ 100,000 and your fixed monthly payment is $ 500, add $ 100 or more to each monthly mortgage payment to pay off the loan faster. Be sure to designate the payments as “principal payment” to your lender.
- Make a lump sum payment. There is no law that says you have to spend a raise, bonus, or inheritance. Use the extra money towards your total loan amount, dramatically reduce your loan amount, and save on interest.
- Make bi-weekly payments. Instead of paying off a loan once a month, pay half the monthly loan amount every two weeks. This way, you make 13 months of loan repayments every 12 months, paying off the loan faster and saving a lot of money on interest.