Getting a mortgage is perhaps one of the biggest expenses in anyone’s financial journey. Paying these off usually spans a couple of decades if not more, in most cases. Amortization is helpful to understand the costs involved in getting and planning your finances for a mortgage.
What is amortization?
The reduction in the value of something over time is called amortization. In accounting, amortization involves reducing the value of a loan or an intangible asset, like a patent or trademark, over a period of time. The value of an asset like a car reduces as it grows older (also known as depreciation), and a loan reduces as you make payments.
Types of amortization
There are mainly two types of amortization: asset and loan.
Asset amortization: Asset amortization is the process of allocating the cost of an intangible asset over its useful life. Useful life refers to the period of time over which an asset fulfills its purpose or loses its value. Tangible assets have a projected lifespan over which one decides their monetary or use value. With tangible assets, depreciation is used to understand how and by how much the value of an asset reduces. When applied to intangible assets – like goodwill, patents, trademarks, or copyrights – it is called amortization.
Loan amortization: Loans can be anything from credit card debt, a mortgage, or a bank loan. Loan amortization indicates the systematic reduction of debt as you pay off the loan through regular, periodic installments.
What is an amortization schedule?
A loan amortization schedule is a record or table that lists all the regular payments you need to make towards a mortgage over the term of your loan. The payment includes both the amount that will go towards the interest and loan principal. You also see the due dates of these payments.
At each point, you will be able to see how much principal is remaining, how much you have already paid off, and how much you will owe at any particular time. Initially, a larger part of your payments goes towards paying the interest. As repayment progresses, more of the payment goes towards reducing the loan principal.
The cost of an asset is tied to the revenue it generates during each accounting period. The cost is calculated by deducting the asset cost from the revenue generated that year or that period. The asset is only written off when it is no longer useful.
Why is amortization important?
Amortization helps in tracking, budgeting, and planning current and future financial investments. For example, if you have an idea of how much mortgage you owe, and there is a sudden cash influx because of a higher-paying job or inheritance funds, you can use these to repay the loan sooner. Understanding how much of the remaining loan consists of interest and how much is the principal can help you make informed decisions about your finances. For example, you may want to consider refinancing your mortgage if the interest rate has decreased.
Amortization of intangible assets can reduce a business’s taxable income, while also reducing the company’s tax liability. This helps investors get a better sense of the company’s true earnings.