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.
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. 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. In this article will cover the following points in depth.
Negative Amortization
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
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
- Annuity
- 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 different types of 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 types of 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 types of 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.
A no-closing-cost mortgage eliminates the need for you to worry about the fees indicated above, as your lender will cover them upfront and offset the cost with a higher interest rate for the term of your loan. You can take an example of Florida no closing cost mortgage to understand better. Closing expenses typically vary between 3% and 6% of the purchase price of the house.
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 types of 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
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.
It 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 types of amortization or level yield types of 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
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
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
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 types of amortization.
Bond Amortization
Bond amortization, also known as debt types of 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. It 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.
Depreciation
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.
- Buildings
- Equipment
- Office furniture
- Vehicles
- Land
- Machinery
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.
Depletion
Unlike various types of 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.
Originally posted 2020-03-08 03:19:53.