What is Amortization?

The term "amortization" refers to spreading the value of a loan or a debt over a series of regular payments or installments comprising of both the principal and interest amount. It generally involves the process where in the value of a loan or an intangible asset is written down over its maturity period.

What Does Amortization of a Loan Mean?

An amortized loan is a type of loan wherein a borrower is required to make schedule or periodic payments to the lender and the payments so made include both the principal and interest amount. Under the amortized loans, the payment made by the borrower initially covers the interest expense for the specified period and thereafter the remaining amount is used to reduce the principal loan amount. 

The interest so calculated on the amortized loan is normally based on the remaining balance of the loan, which gradually decreases as the payments are made periodically. There is an inverse relationship between the principal and interest that are paid over the period of amortized loan because as the periodical payments are made the loan amount gets reduced and then the interest is calculated on the remaining balance of the amortized loan.

How is Amortization of a Loan Calculated?

The amortized loans are usually calculated using various financial tools and software such as calculators, Microsoft Excel. The amortization schedule is prepared which displays the current outstanding loan amount, and in case where the payments are required to paid on monthly basis, the interest portion is calculated by multiplying outstanding loan balance with a pre specified interest rate. The resultant is then divided by 12 to give us monthly interest amount.

The principal due for a given month is then calculated by subtracting the monthly interest payment from the total monthly payment. 

What is a Amortization Schedule and Why is It Prepared?

The interest payment for the next month is then calculated on the new outstanding balance which is difference between the previous month's outstanding balance minus the principal amount for the previous month. This continues until all the principal payments are made and the loan amount is zero.

The amortization schedule is a table that helps in computing loan payments that are to be made periodically by the borrower, which includes the principal amount and the interest amount and shows the computation chart until the loan amount is paid in full and balance is zero.

The initial part of the amortization schedule covers the maximum interest and the later part shows the principal amount. The amortization schedule helps the lender to keep a track of how much they owe from the borrower and when is the payment next due. It also helps in knowing the interest amount and the principal amount due.

Why are Mortgage Loans Amortized?

A mortgage is generally opted by those people who fall in the low- or medium-income groups and want to buy a house but because of the high investment involved it becomes impossible for them to buy a dream house of their choice. The mortgage is a type of an amortized loan, which gives them that option to buy a house wherein they are required to make repayment of the loan not in lump but in a regular installment payment spread over a period of time. The amortized period is chosen by the borrower to pay off the debt in its entirety to the lender.

The borrowers have an option to for fixed rate mortgage wherein the interest rate is fixed for the entire tenure of the mortgage, which may vary from 15 years to 30 years. 

How Does Amortized Period Affect the Interest to Be Paid on the Mortgage Loan?

The amortization period not only impacts the tenure for repayment of the loan, but also the interest that is required to be paid during the amortized period. The interest which the borrower is required to pay during the amortized period of the loan is much higher when the tenure is long, on the other hand when the amortized period is shorter the amount of interest paid by the buyer to the lender is much less. The longer amortized period, although reduces the monthly repayment of installments but increases the amount of interest that is to be paid during mortgage period.

The amortization schedule typically highlights interest rate and principal due during the mortgage period of the loan and it can seen how the interest amount varies during the amortization period depending on the chosen tenure. 

Why is Amortization Important? 

The amortization helps the businessmen and investors around to keep a check of their cost that they are going to incur in the coming period and in the context of repayment of loan during the mortgage period it provides a clear picture of the amount of interest and principal due during the tenure which in turn helps in to deduct interest expenses while computing tax liability. The tax liability of the businessmen also gets reduced when the amortization of intangible assets is also done.

Common Mistakes

The care must be taken while calculating the interest amount and equally monthly installments for each loan. Sometimes when the installments are to be calculated monthly, the principal amount is usually divided by 6 instead of 12 to get the monthly installments. Also, the tenure of the loan and the interest rate is populated differently in the calculator by mistake which leads to all together a different result.

Formulas

The formula for calculating principal amount due on an amortized if payments are made monthly 

Principal amount = ¹Total monthly payment - (Outstanding loan balance× Interest rate ÷ 12)

Note: The total monthly payment is normally specified when a loan is taken.

In case where a borrower wants to compute the total monthly payments on its own, the below mentioned formula is to be used:

Total monthly payment = Loan amount [i(1+i)ⁿ / ((1+i)ⁿ-1)]

Here,

i = monthly interest rate, which is computed by dividing the annual interest rate by 12.

n= number of monthly payments, which is computed by multiplying the number of years by 12.

Context and Applications

This topic is significant in the professional exams for both undergraduate and post-graduate courses, especially for:

• B.com (Honors)
• M.com
• Chartered Accountants (CA)
• Company Secretary (CS)
• MBA (Finance)
• CFA (Certified Financial Analyst)

Related Concepts

• Accelerated Amortization.
• Self- Amortizing loan.
• Amortization of Assets.

Practice Problem

A man takes a car loan of $30,000 at 4% interest for 3 years where the monthly payment is going to be $885.72, so the monthly loan amortization schedule would be as follows:

The above calculation will continue till the 36th month until the principal balance becomes zero. It is to be noted however, that total monthly payments are typically mentioned when the loan is taken which remains the same throughout the loan tenure period.