Amortization is the process of paying off a loan or mortgage in a series of fixed payments. The monthly installment remains constant but principal and interest are paid off in different amounts each month.
At the beginning, interest amount is higher. Gradually, as the outstanding loan balance reduces, interest amount also decreases and the loan or mortgage is completely paid off at the end of maturity period.
Mortgage or loan amortization schedule can be calculated using modern financial calculators or online amortization charts. You can also use mathematical formulas in excel spreadsheet to create an amortization table.
Amortization is also an accounting term used in financial accounting which refers to spreading out the cost of an intangible asset over its useful life. In this article will cover the following points in depth.
- Negative Amortization
- Amortization Schedule
- Different Types Of Amortization
- Amortization Of Intangible Assets
Typically, amortization means paying off the mortgage with regular payments so that your principal amount decreases over time. In negative amortization or reverse amortization, even after paying regular payments, your principal amount keeps on increasing.
Negative amortization happens when the mortgage payment is less than the interest cost. For example, if the monthly interest payment is $1000 and the borrower pays $900, then the remaining $100 is added to the principal amount every month.
Negative amortization, also known as deferred interest or graduated payment mortgage is a reverse phenomenon, where the principal balance increases if the borrower fails to make regular payments to cover the interest cost of the mortgage.
How Negative Amortization Works
Certain lenders allow you to pay only a certain amount of interest each month and the unpaid interest is added to the principal of the loan. This process of adding interest to the loan amount is known as capitalization of interest.
Due to this you have to pay not only the interest on the principal amount but also interest on interest. This increases the amount of debt and the cost of loan. Eventually you have to pay off the loan which can be done in several ways.
- Making regular amortizing payments
- Refinancing the loan
- Making a balloon payment of pay off the loan
Purpose Of Negative Amortization
The main purpose of negative amortization is to reduce the mortgage payments at the beginning of the amortization schedule. It is used for this purpose on both fixed rate mortgages and adjustable rate mortgages.
Another purpose of negative amortization is applicable to adjustable rate mortgages. When the interest rates rise, mortgage payments can increase in large amounts. Negative amortization can help you to reduce the potential for payment shock.
The disadvantage of negative amortization is that the mortgage payment should be increased later. Larger the amount of negative amortization, larger the increase in payments required to fully amortize the loan.
Amortization schedule or amortization table is the list of periodic down payments required to completely pay off the mortgage. Each monthly payment is of equal amount and contains two components, interest cost and principal payment.
By looking at the amortization schedule before applying for home loan or car loan, you can know about your monthly payments, the total cost of borrowing and how long it will take to pay off the loan.
Mortgage and loan amortization calculators are available on most of the popular financial websites. You can also create an amortization table in excel spreadsheet using formula. There are different methods used for the calculation of amortization schedule.
- Straight Line
- Bullet Payment
- Balloon Payment
- Declining Balance
- Increasing Balance
Structure Of Amortization Table
Amortization table is a chart which helps you to keep track of your monthly payments as per amortization schedule. The last line of the schedule shows the total interest and principal payments for the entire duration of mortgage.
Amortization table contains columns for scheduled payments, interest expenses and principal repayment. Each entry in the table is a single monthly payment towards the loan which can be broken down into principal and interest.
At the beginning, most of the payment is allocated for reducing the interest on the loan. As the schedule progresses, greater percentage goes towards principal and a lower percentage goes towards interest.
Your monthly payments don’t change and the last installment will pay off the remaining amount of your debt. People who want to pay off their home loans or auto loans faster make extra payments at the beginning of the schedule.
Amortization Schedule With Extra Payments
Also known as accelerated amortization, it is a process of making extra payments towards mortgage principal so that the borrower can pay off the mortgage before settlement date and save little money on mortgage interest.
A borrower who is making extra payments every month may have to specify that the additional amount should go towards reducing the loan principal rather than next month’s loan payment.
Since these extra payments reduce the outstanding loan balance, the interest costs automatically decrease with each subsequent payment. This helps in reducing the total interest amount on the loan.
Amortization Schedule With Balloon Payments
A balloon payment is a large payment which is made at the end of the mortgage or loan schedule. It is similar to bullet payment which is used to make a single large payment on fixed income investments like bonds.
Balloon mortgage usually has a very short duration from 5 years to 7 years and only interest component is amortized over the duration. The principal is paid at the end of the duration as a single large payment.
Balloon payments are mostly used in commercial real estate rather than residential real estate. At the end of schedule, the borrower can make a balloon payment by refinancing the mortgage or by making entire payment in cash.
Balloon payments can give you the advantage of making lower monthly payments for shorter duration. If interest rates are higher at the beginning, borrower can refinance the balloon payment possibly at lower interest rates at the end of schedule.
Different Types Of Amortization
- Straight Line Amortization
- Mortgage Style Amortization
- Line Of Credit Amortization
- Investment Amortization
- Re-Amortization Or Refinance Amortization
- Effective Interest Amortization
- Accumulated Amortization
- Insurance Amortization
- Self Amortization
- Interest Only Amortization
- Bond Amortization
- Fixed Rate Amortization
Straight Line Amortization
Straight line amortization is also known as linear or fixed principal amortization as the amount towards principal payment remains constant every month. But the interest amount varies according to the outstanding loan balance.
Your monthly installment payments are not constant with higher monthly installment at the beginning of the loan. Gradually, as the outstanding loan reduces, monthly installment payments also reduce as the interest applied on the loan decreases.
Mortgage Style Amortization
Mortgage style amortization is also known as constant payment or equal payment amortization as the monthly installment payments remain constant during entire mortgage schedule.
Installment payments are constant but the principal and interest amount is not equal. The interest component is higher at the beginning and gradually reduces as the outstanding loan balance decreases.
Line Of Credit Amortization
Line of credit is similar to credit card where you can borrow from the available pool of money. It has a draw period and a repayment period. You can borrow the money during draw period and repay the principal and interest during repayment period.
Line of credit amortization schedule will tell you the total duration of your repayment period and the amount of money you have to repay during each period. Lines of credit are usually unsecured but some lenders require that you put up collateral.
Investment amortization mostly involves fixed income instruments which are purchased at a discount or premium to face value, when the interest rate is different from the coupon rate of such fixed income investments.
Investment amortization determines the real interest rate by allocating the total discount on premium to each interest paying period. When the investment is fully amortized, the face value will be equal to the outstanding value.
Re-Amortization Or Refinance Amortization
Refinance amortization is a method of refinancing the existing mortgage without restarting the mortgage. It can help you to lower your monthly payments in an environment where interest rates are declining.
It is also known as loan recasting which requires you to pay a specific amount towards the principal balance of the mortgage. This helps you to pay off your mortgage faster and it recalculates the monthly payments to reflect the new balance.
Effective Interest Amortization
Effective interest amortization is also known as constant yield amortization or level yield amortization which is used to amortize the bond over its remaining life.
The amortization amount is calculated as the difference between the cash paid for the interest and the calculated value of bond’s interest.
Accumulated amortization is the cumulative amount which has been charged over the years to reduce the value of an intangible asset.
When an intangible asset is terminated, the amount associated with the accumulated amortization is also removed from the balance sheet.
Insurance amortization refers to the process of amortizing the coverage over the life of the policy. Amortization period of the insurance policy is the period for which the coverage is provided by the insurance policy.
Self amortization is the default structure for mortgage and loans. Self amortizing mortgage is one in which the borrower pays of the principal and interest as per the amortization schedule until the loan is paid off. It is also known as full amortization.
Interest Only Amortization
In interest only amortization, the borrower does not repay the principal for entire amortization schedule. At the end of maturity period the principal is paid off as a lump sum amount. It is also known as partial amortization.
Bond amortization, also known as debt amortization is the amortization of premium on bonds payable where the principal and interest on the bond are paid at regular intervals over the life of the bond.
Fixed Rate Amortization
Fixed rate amortization is applicable to fixed rate mortgage where the interest rate remains constant for the mortgage schedule. It helps the borrower with his financial planning as the monthly payments remain constant.
Amortization Of Intangible Assets
Amortization is also used in financial accounting which refers to the process of spreading out the cost of intangible assets over a period of time. Amortization can help you to reduce the taxable income throughout the lifespan of intangible assets.
Let’s say you have spent $10,000 in designing and creating a machine. You patent the machine and the patent expires in 10 years. In this case you will have to record $1000 as annual amortization expense for the patent.
Amortization is used to gradually write down the cost of intangible assets that have a specific useful life. It is a process of shifting assets from balance sheet to income statement which reflects the consumption of intangible assets over their useful life.
Amortization is similar to depreciation but it can be used only for intangible assets. Intangible assets are items that do not have any physical presence but they add value to your business. Few examples of intangible assets are listed below.
- Patents and trademarks
- Franchise agreements
- Proprietary processes, like copyrights
- Cost of issuing bonds to raise capital
- Organizational costs
Amortization for intangible assets is calculated using straight line method, meaning the same amount is deducted every year. As a general rule, assets should be amortized over the useful life. If an intangible asset has an indefinite life it cannot be amortized.
The difference between amortization and depreciation is that depreciation is used for tangible assets. Tangible assets are physical assets which can be seen and touched. Few examples of tangible assets are listed below.
- Office furniture
Like amortization, depreciation can be used to spread out the cost of long-term assets over their lifespan. You can write down the cost of tangible assets every year to reduce your taxable income. Depreciation is calculated evenly over the lifespan of the assets.
Some tangible assets may have residual value at the end of their expected life which is known as salvage value or resale value. Depreciation for such assets is calculated by subtracting the salvage value from the original value.
Unlike amortization and depreciation which are used for assets, depletion can only be used for natural resources. It is a process of allocating the cost of natural resources used by the company from balance sheet to income statement over the years.
In order to calculate the depletion cost of natural resources, all the phases of production should be taken into consideration. The four main phases of production are acquisition, exploration, development and restoration.
Depletion methods are of two types, percentage and cost. In percentage depletion a fixed percentage of gross revenue is allocated as depletion cost whereas in cost depletion the cost is calculated using the basis, reserves and number of units sold.