Amortisation is an accounting tool used to decrease the value of an intangible asset or loan over a fixed period of time.
In the case of a loan, amortisation is when loan payments are scheduled over a specified period to reduce the loan value gradually. This amortisation schedule is typically used by lenders to determine loan repayment over a period of time depending on a predetermined loan maturity date.
In the case of an intangible asset, capital expenses associated with the asset are spread over a period of time, depending on the life of the asset. Amortisation of an intangible asset is typically used for tax purposes.
Types of amortisation
1) Full amortisation
A loan with full amortisation has scheduled repayments and is fully paid off upon loan maturity. Most loans typically come with full amortisation.
Generally, at the start of a fully amortised loan, a larger proportion of the payment goes towards the repayment of interest. Subsequently, moving towards the middle of the loan term, an equal amount of the payment goes towards the repayment of the interest and principal. Towards the end of the loan term, a more significant proportion of the payment is used to repay the principal of the loan.
2) Partial amortisation
A loan with partial amortisation means that a portion of the loan’s principal is repaid every month based on the repayment schedule. And upon loan maturity, there exists an outstanding balance on the loan; the loan is still not fully repaid. Thus, a loan with partial amortisation typically carries a higher risk of default, especially with larger loan balances. Partially amortised loans often appear in specific business lending arrangements, such as commercial real estate. This is because partially amortised loans require a much lower monthly payment, giving time for projects to grow and earn revenue.
A loan with interest-only payments requires the borrower to repay only the monthly interest based on the initial principal amount. The monthly payment remains unchanged, with the full principal amount remaining at the end of the repayment schedule. By then, the borrower can either repay the principal in full or take on a new loan. Fixed-rate interest-only loans are not typical, and they usually appear in longer-term loans, such as a 30-year mortgage. This is because an interest-only mortgage allows homebuyers to defer large payments into future years when they expect higher income.
4) Negative amortisation
A loan with negative amortisation typically occurs when the borrower is unable to repay the full interest payment required based on the monthly schedule. In this case, the unpaid interest for the month will be added to the loan’s principal balance, causing it to increase over time. To avoid negative amortisation, borrowers should try to pay off at least all of the interest and some of the principal owing. .
How to calculate amortisation?
Since amortisation refers to the process by which debt is paid off based on a repayment schedule, it is calculated using financial calculators or digital applications.
The formula to calculate the monthly principal due on an amortised loan is as follows:
Principal Payment = Total Monthly Payment – [Outstanding Loan Balance x (Interest Rate / 12 Months)]
This total monthly payment is usually calculated by the lender and stated in the loan terms beforehand.
Example of amortisation
Here is an example of an amortisation schedule for a two-year $20,000 loan with a 3% interest rate.
The total monthly payment is $859.62, which includes the interest of $50 ($20,000 balance x (3% interest rate/12 months)) for the first month. The interest amount slowly decreases over time, whilst the amount going to the principal balance increases over the loan term, with the total monthly payment remaining the same each month. At the end of 24 months, the remaining balance of the loan is $0, so this is a full amortisation loan.
Why is amortisation useful?
Amortisation is useful as it offers a guaranteed way to pay off a mortgage. An amortised loan allows payment to be spread out evenly throughout the loan period, providing a more feasible repayment schedule. In addition, amortisation provides businesses and investors with a clear set of payment amounts for interest and principal, enabling both parties to better gauge their expenses over time. Amortisation may also be tax deductible but this depends on the income tax legislation of single countries.
Amortisation versus depreciation
Amortisation and depreciation are used to calculate the cost associated with an asset over a certain period. However, amortisation refers to lowering the value of an intangible asset over time, whilst depreciation refers to the loss in value of a tangible asset, potentially due to physical usage, and wear and tear. In addition, unlike depreciation, amortisation generally has an equal payment throughout the loan term, whilst that of depreciation may differ.
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Disclaimer: The information and/or documents contained in this article does not constitute financial advice and is meant for educational purposes. Please consult your financial advisor, accountant, and/or attorney before proceeding with any financial/real estate investments.