As part of an accounting procedure, amortization is the process of lowering the book value of an asset or loan over a finite period of time. During the amortization of a loan, payments are spread out over a period of time. This concept is similar to depreciation and amortization that reduces book value with time and usage.
In simple words, the amortization of a loan can also be referred to as the process for writing down the value of a loan or even an intangible asset. Furthermore, amortization schedules are rendered by lenders. And these lenders are the financial institutes and other monetary institutions that lend monetary benefits to the organizations or individuals. To understand the amortization schedule, it’s important to understand the following terms.
It refers to the amount of money you owe the lender at a specific period of time. A pre-agreed rate of interest is applied to this amount to calculate the interest charge for the year. If the interest remains unpaid in accounting books, it’s also reported as a liability in the financial statement.
It’s the amount charged by a lender on their funds. Usually, it’s a percentage that is fixed at the time of entering into the contract.
That’s a pre-agreed schedule that is agreed between the lender and borrower of the funds. Sometimes, both parties agree on modifications in terms of the loan, referred to as restructuring of the loan/repayment schedule.
To calculate the amortization of monthly payments. Here is the formula that will provide principal due and the interest on an amortized loan.
Principal Payment = TMP − (OLB × Interest Rates / 12 Months)
TMP = Total monthly payment
OLB = Outstanding loan balance
Example of Amortization
Let us take an example of a loan that needs to be amortized throughout one year. The sum borrowed is $5,000 as a personal loan. And the markup or the interest rate is 6% per annum, along with fixed monthly repayment of $430.33.
Divide the interest rate by months in a year = 6% / 12 = 0.5%
Further, the interest can be calculated by applying the monthly rate of interest with the opening liability. For instance, the interest expense amounts to $25 (5,000*0.5%) in the first month of amortization. In subsequent years, the same rate of interest is to be used. However, liability is expected to reduce due to repayment of the loan.
The following chart here determines the complete schedule for the loan amortization for the complete life of the loan.
Loan Amortization Schedule
Understanding amortized Loan Working
Monthly payments have been made in the above schedule that led to a reduction in the interest payable recorded in the balance sheet. Further, due to the fact that any payment that is excess of interest amount reduces the principal that is considered repayment of the loan. For instance, in the first month of our example, the $430.33 results in liability reduction by $405.33.
The interest due is determined by multiplying the current loan balance by the prevailing interest rate in the current period. The monthly interest rate can be calculated by dividing the annual interest rate by 12.
The principal paid for the period is calculated by subtracting interest due from the total monthly payment. The principal paid after deduction of interest brings you to the outstanding balance for the loan, which can be disclosed as closing balance in the business’s financial statement.
The columns of interest impact the income statement as this amount is charged in the income statement. On the other hand, the liability keeps decreasing as we move ahead in the loan schedule.
This is because monthly payment contains a certain portion of the principal repayment, and at the end of the loan life, it’s fully repaid. However, in some arrangements, liability may not decrease in the same manner as above.
At the end of the accounting period, the business can use an amortization schedule to calculate the current liability portion. The next 12 portions of the capital repayment will be counted to calculate the current portion, it’s because interest on the liability has not been accrued as of the balance sheet date. The existing liability in the next twelve months is capital repayment on the balance sheet date.
Since our example is only for one year. Hence, we cannot bifurcate liability in the current and non-current portions.
To make an accuracy check on our amortization table, sum up the monthly payment column, which totals $5,164. Similarly, the column for the interest totals $164. The deduction of $164 from $5,164 leads to $5,000 which is the principal amount of the loan. Hence, our calculation is correct.
Loans vs. Revolving Debt vs. Balloon Loans
Revolving debts like credit cards, amortized loans, and balloon loans are similar. Consumers should familiarize themselves with their distinctions before signing up for any.
In general, amortized loans are repaid over several months, with a fixed amount paid per month. The principal owed can be further reduced by paying more, so there is always the option to pay more.
Revolving debts are most commonly associated with credit cards. These debts are revolving and are based on a credit limit. To keep borrowing, you don’t need to reach your credit limit yet. Furthermore, the cardholders have no set payments or fixed loan amounts, so they are different from those who take out amortized loans.
An amortization period of several years is usually the norm for balloon loans, and the entire principal balance is only amortized to a certain extent.
Final repayment is usually a payment that is at least double what has been paid in previous payments; this payment is due at the end of the loan term.
Amortization is used to allocate the cost of the loan over the life of the loan. The loan cost may fall in interest expense, the redemption premium, and applicable fees on the loans.
Premium on reduction and related fees of the loan is deducted on initial recognition of the loan. The loan’s effective rate is fixed so that the cost of the premium and the interest is spread over the complete life of a loan.
The monthly payment for the loan contains the cost of the interest and portion of the principal. As the borrower keeps paying for the monthly installment, the net liability keeps decreasing. At the end of the loan age, the loan balance reduces to zero as all liability has been repaid.
Frequently asked questions
How to get better rates on the loan amount?
Following actions can help to get better rates on the loan amount.
- Maintenance of a good credit score.
- Look for seasonal offers.
- Maintain good employment history.
- Use collateral.
What is the effective rate of interest?
The effective rate of interest is the real cost of the loan of financial product, and it incorporates the cost of loan issuance, any premium, and the interest cost.
How maintenance of a good credit score helps to get a lower rate of interest on the loan?
The maintenance of a good credit score assures the lender that,
- You are good at managing finance.
- You have a good history of meeting deadlines.
- You’re a reliable person.
Hence, it reduces the overall risk in the lender, leading to a reduction in the loan cost.
What’s included in the cost of loan issuance?
The loan issuance cost includes appraisal fee, commission paid to investment banks, fees paid to auditors, regulators, marketing expenses, SEC registration fee, audit fee, etc.