amortization definition and meaning

amortization definition

Depreciation is the expensing of a fixed asset over its useful life. Some examples of fixed or tangible assets that are commonly depreciated include buildings, equipment, office furniture, vehicles, and machinery. An amortization schedule is a complete schedule of periodic blended loan payments showing the amount of principal and the amount of interest.

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Another difference is the accounting treatment in which different assets are reduced on the balance sheet. Amortizing an intangible asset is performed by directly crediting that specific asset account. Alternatively, depreciation is recorded by crediting an account called accumulated depreciation, a contra asset account. The historical cost fixed assets remains on a company’s books; however, the company also reports this contra asset amount to report a net reduced book value amount. The interest portion is the amount of the payment that gets applied as interest expense. This is often calculated as the outstanding loan balance multiplied by the interest rate attributable to this period’s portion of the rate. For example, if a payment is owed monthly, this interest rate may be calculated as 1/12 of the interest rate multiplied by the beginning balance.

Fully Amortizing Payments On An Adjustable Rate Mortgage (ARM)

The only way your payment changes on a fixed-rate loan is if you have a change in your taxes or homeowner’s insurance. With an ARM, principal and interest amounts change at the end of the loan’s fixed-rate period. Each time the principal and interest adjust, the loan is re-amortized to be paid off at the end of the term. In short, it describes the mechanism by which you will pay off the principal and interest of a loan, in full, by bundling them into a single monthly payment. This is accomplished with an amortization schedule, which itemizes the starting balance of a loan and reduces it via installment payments. In business, amortization allocates a lump sum amount to different time periods, particularly for loans and other forms of finance, including related interest or other finance charges. Amortization is also applied to capital expenditures of certain assets under accounting rules, particularly intangible assets, in a manner analogous to depreciation.

Negative amortization is an amortization schedule where the loan amount actually increases through not paying the full interest. An amortization scheduleis often used to calculate a series of loan payments consisting of both principal and interest in each payment, as in the case of a mortgage. Though different, the concept is somewhat similar; as a loan is an intangible item, amortization is the reduction in the carrying value of the balance. First, amortization is used in the process of paying off debt through regular principal and interest payments over time.

What Is A Fully Amortized Loan?

An amortization schedule is used to reduce the current balance on a loan—for example, a mortgage or a car loan—through installment payments. Amortization can demonstrate a decrease in the book value of your assets, which can help to reduce your company’s taxable income. In some cases, failing to include amortization on your balance sheet may constitute fraud, which is why it’s extremely important to stay on top of amortization in accounting.

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Regardless of whether you are referring to the amortization of a loan or of an intangible asset, it refers to the periodic lowering of the book value over a set period of time. Having a great accountant or loan officer with amortization definition a solid understanding of the specific needs of the company or individual he or she works for makes the process of amortization a simple one. Fixed/tangible assets are purchased and used, they decrease in value over time.

Depreciation Methods

The initial period is how long your interest rate stays fixed at the beginning of the loan. When you’re comparing adjustable rate mortgages, it’s important to know what you’re looking at when comparing rates. If you see a 5/1 ARM with 2/2/5 caps, that means that the initial rate will stay fixed for 5 years and change once per year after that. In this case, the payment could go up 2% on the first adjustment and 2% on each subsequent adjustment.

amortization definition

Likewise, you must use amortization to spread the cost of an intangible asset out in your books. If you pay $1,000 of the principal every year, $1,000 of the loan has amortized each year.

The Amortization Schedule Formula:

Amortization is a term people commonly use in finance and accounting. However, the term has several different meanings depending on the context of its use.

The total payment stays the same each month, while the portion going to principal increases and the portion going to interest decreases. In the final month, only $1.66 is paid in interest, because the outstanding loan balance at that point is very minimal compared with the starting loan balance. The word amortization simply refers to the amount of principal and interest paid each month over the course of your loan term. Near the beginning of a loan, the vast majority of your payment goes toward interest. Over the course of your loan term, the scale slowly tips the other way until at the end of the term when nearly your entire payment goes toward paying off the principal, or balance of the loan.

Examples of amortize in a Sentence

Amortization.The method of allocating the cost of an intangible asset over time for purposes of offsetting such cost from revenues the asset helps to produce. An amortization schedule shows how the borrower’s payments are broken down over the life of the loan. As mentioned previously, the majority of the payments for the first five years of the loan goes to interest. Accounting and tax rules provide guidance to accountants on how to account for the depreciation of the assets over time. The amortization of a loan is the process to pay back, in full, over time the outstanding balance.

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