What is Loan Amortization?

September 23, 2021

Loan amortization is the process of spreading out loan payments over a period of time to reduce upfront costs.

Are you looking to get a loan and wondering what loan amortization is? If you’re not very loan savvy, the amortization definition might be new to you. This term takes into consideration many variables in order to calculate payments and how they relate to the interest and the principal balance. 

What is Loan Amortization?

This term can be used in calculations regarding loans and loan payments, or the expenses of an intangible asset. An intangible asset is the opposite of physical assets or tangible assets. It instead has no physical substance, like a copyright or a patent. This article primarily discusses how amortization relates to loans. 

Loan amortization has to do with calculations made to spread out loan payments over a set period of time, kind of like how installment loans spread out their loan payments into parts. These calculated loan payments don’t just spread out loan payments into installments, they also take into consideration how each loan payment will tackle the overall interest. 

Usually, a loan will come with an annual interest rate. But then what does this mean for your loan payments if they only last for a few weeks or a few months? What does this mean for your loan payments if they last longer than a single year? And how much interest vs principal balance is being paid in each loan payment? Amortization calculations cover all of these questions. 

For example, if you take out a loan for $500 and you want to spread that loan into 4 equal payments then you would simply divide $500 by 4 payments to get $125. But then this $500 loan also has an interest rate of 2%. Now you also have to figure that 2% interest into your loan payments. That’s where accounting and amortization calculations come into play. 

What is an Amortization Schedule?

After completing the necessary calculations, an amortization table or amortization schedule might be created to outline each payment. This 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 table can then act as a kind of balance sheet to outline your loan terminology as they relate to your actual monthly payment schedule. 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 payments. 

Part of each payment will go toward the principal and another part of each payment will go toward the interest. The first payments on your loan are often mostly toward the interest, so don’t let this surprise you too much. The interest is like the payment you make toward the lender for the loan. So this usually comes first while payments toward the initial amount come later. 

What is Negative Amortization? 

Negative amortization occurs when the amount that someone is paying on a loan isn’t enough. When this happens, as you make a loan payment the total amount you owe doesn’t actually go down. 

Some lenders might let you make smaller loan payments due to mitigating circumstances. This includes making monthly payments that are too small to actually bring your loan amount down. But eventually larger payments that will start to actually take care of the loan interest and principal will start being scheduled. 

If negative amortization goes on for too long, the interest will only accumulate and not get paid off, causing your loan to cost more than it was actually worth as in the case of a home mortgage loan. If your mortgage exceeds the worth of your actual home, that could put you in a bind. 

This will then make your house harder to sell because it won’t actually be worth your selling price and you’ll lose money. It can also make the mortgage payments overwhelm you as the loan amount continues to grow instead of decrease making it hard to make mortgage payments, putting you at risk of foreclosure, and potentially making your mortgage payments too large. This can also make it so you end up paying interest on your interest. 

Amortization Vs Depreciation

Amortization and depreciation can both apply to assets as well as loans. The costs of an asset have to do with amortization and the value of an asset has to do with depreciation. But both amortization and depreciation are terms that can apply to calculations for the value of your assets. 

When applied to assets, the amortization can calculate and spread out the costs of an intangible asset over its lifetime. Meanwhile, depreciation can calculate the costs of a tangible asset over its lifetime. These calculations are important for understanding the value of an asset as well as sorting out tax deductions and tax liabilities for those assets. 

An intangible asset is a financial resource that you cannot see. Some examples of intangible assets include goodwill, brand awareness, intellectual property, patents, trademarks, and copyrights. 

A tangible asset is a financial resource that you can see. A tangible asset can also be referred to as a fixed asset or a physical asset because it has a physical substance. Some examples of tangible assets include cash, vehicles, buildings, or equipment. 

Businesses need to understand how much they are spending and gaining on their assets, so they use amortization and depreciation calculations to figure out those numbers. 

In Conclusion, 

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.