Learn all about loan amortization, what it means, and how it works so you understand how this process works with loans and assets.
Whether you are an accountant, starting your own small business, or taking out a loan, it’s helpful to understand basic loan terminology so you can better take advantage of loans and assets.
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What is Amortization?
Loan amortization is the process of spreading out loan payments over time through regular, scheduled payments. Amortized loans include regular payments where each payment helps pay off a portion of the loan principal and accrued interest.
This term that can be used in calculations regarding loans and loan payments, or the expenses of an intangible asset. This term takes into consideration many variables in order to calculate payments and how they relate to the interest rate, the principal balance, and principal payments.
The amortization process exists to make sure the loan is paid off, the principal and any accrued interest, by the end of the loan term. The amortization schedule works to give borrowers a clear loan repayment plan to achieve this goal of eventual full repayment.
What is an Amortization Schedule?
An amortization schedule is a table or chart that outlines each loan payment and how much of that payment goes toward the loan's principal and accrued interest.
The amortization table will go over all the numbers in relation to the loan payment like the total loan amount, the total payment due, how much of that payment is interest, and how much of that payment is the loan principal.
This can be helpful to not only see your minimum payments and your loan terms in action, but it also shows the payments on the principal balance and interest.
How Do Amortizing Loans Work?
Instead of paying off a loan all at once, an amortizing loan spreads out the loan's principal and interest repayments over a set period of time. Using a repayment schedule like this can make paying back loans easier for borrowers.
The amortization process works by creating a schedule of regular, often monthly, payments that will pay off the entire loan over a set period of time. Each payment will serve to pay off a portion of the loan's principal and interest. Depending on the loan's schedule, payments at the beginning might include more of the loan's principal or interest to pay off that part of the loan first. By the end of the amortization schedule, the entire loan, including the principal and interest, will be fully repaid.
What is Negative Amortization?
Negative amortization is when the loan payment amounts are not enough to cover the interest accruing on the loan. This can then cause the loan's outstanding balance to increase over time instead of decrease.
Some loans might let you make smaller loan payments due to mitigating circumstances. This can include making monthly payments that are too small to decrease your outstanding balance. But eventually larger payments will need to be made in order to bring the outstanding balance down and eventually pay off the loan.
Amortization Vs Depreciation
Amortization and depreciation are similar in that they are both accounting methods and they can both be used to allocate the cost of an asset over time.
Amortization and depreciation are different in that they are both applied to different types of assets and they both serve different accounting purposes.
Amortization refers to the process of spreading out loan repayments over time, but can also be used for intangible assets like patents, copyrights, and trademarks. It spreads out the cost of an intangible asset over time, specifically over its estimated useful life.
Depreciation is used for tangible assets like machinery, equipment, buildings, and vehicles. It shows an asset's costs over time and how an asset's value will decrease over time, specifically over its estimated useful life.
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