How Amortization Works


If you've ever had a mortgage, you already know a lot about amortization.
If you've ever had a mortgage, you already know a lot about amortization.
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The ancient roots of the word "mortgage" come from Old French: mort for "death" and gage for "pledge." Anyone at risk of defaulting on a mortgage payment knows what it feels like to have signed a so-called "death pledge," but that isn't how the word was originally used. Instead, if the mortgage was repaid with interest, then the debt was considered "dead." Likewise, if the borrower defaulted, his rights to the land were also dead [source: Harper].

If you know how mortgages work, then you probably know a little about amortization. For the uninitiated, amortization is a method for paying off both the principle of the mortgage loan and the interest in one fixed monthly payment. Amortization is calculated precisely to pay off both principle and interest over a set period of time, known as the term of the loan. Amortization comes from that same Old French root as "mortgage" and means the "killing down" or "extinguishing" of debt over time.

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The beauty of amortization lies in its consistency. Every single monthly mortgage payment over the 30-year term of the loan is exactly the same amount. If you take out a $150,000 mortgage at a 5 percent annual interest rate, amortization allows you to pay $805.23 each and every month. That amount lets you to pay back both the principal of the mortgage ($150,000) and the total compounded interest ($139,883.68) in exactly 30 years, in 360 monthly installments. The interesting part of amortization is that every mortgage payment, despite being equal, contains different amounts of principal and interest. But we'll talk more about that later.

There's also a second use of the word amortization, this time in business accounting. This type of amortization refers to the accounting practice of spreading out the cost of a business expense over a number of years. Why would a business want to do this? So it doesn't have to report a big, one-time loss on its balance sheet. Instead, it can soften the blow of the expense -- and give the investment time to bear fruit -- by amortizing it over as many as 20 years. We'll also discuss that in more detail, but for now, let's go back to mortgages and see how amortization is both a blessing and a hidden curse to homeowners.

Amortization and Mortgages

Amortization is the mathematical calculation at the heart of a fixed-rate mortgage that makes home-buying more affordable. Mortgages weren't always the 30-year, low-interest loans we know today. When the first mortgages were issued in the 1930s, they were short-term loans (five to seven years) that only covered 50 percent of the total value of the home [source: U.S. Department of Housing and Urban Development]. To make things worse, most of the mortgage payments only covered the interest on the loan, which meant the borrower was forced to make a huge "balloon payment" at the end of the term to pay off the principal.

The Federal Housing Authority (FHA), created in 1934, helped make home ownership possible for millions of Americans by introducing the 30-year, fixed rate loan, which is now the standard mortgage loan. This type of mortgage is said to be self-amortizing, because the fixed rate and fixed term make it possible to calculate a fixed monthly payment that will steadily pay off both the interest and principle over 30 years.

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To understand how amortization works, you really need to look at an amortization table. Bankrate.com has a simple amortization calculator with an option for viewing the full amortization table. Let's use the example of a $150,000 mortgage loan with a fixed interest rate of 5 percent and a term of 30 years. The fixed monthly payment on such a mortgage would be $805.23 for 360 months. What the amortization table shows you is the exact breakdown of each $805.23 payment -- how much is principal and how much is interest.

Looking at the amortization table for our example mortgage, the first payment is almost entirely interest: $625 interest to $180.23 principal. In fact, the borrower won't start paying off more principal than interest until he or she's 16 years into the mortgage. The real shocker of the amortization table is the total interest paid over that 30-year stretch: $139,883.68. That's nearly the full amount of the original loan!

That's why amortization of mortgages is both a blessing and a curse to homeowners. It's a blessing because it allows borrowers to budget for a fixed monthly payment and not worry about the sudden rate changes built into adjustable-rate mortgages. But stretching out payments over such a long term also means lots of compounded interest. Plus, if you sell the house early, you'll have paid off very little of the principal, meaning a smaller cut of the sale price.

Now, let's look at the other meaning of amortization.

Amortization and Business Accounting

Accrual accounting -- another form of amortization -- allows companies to spread the cost of certain expenses over several years.
Accrual accounting -- another form of amortization -- allows companies to spread the cost of certain expenses over several years.
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A business measures its success by its balance sheet. More importantly, so do investors. The balance sheet lists all of the earnings and expenses that determine if the fiscal year ends in a profit or a loss. To please shareholders and prospective investors, business owners try to keep as much in the positive column as possible and limit the negative impact of expenses. One way to do that is through two important accounting principles: depreciation and amortization.

Depreciation and amortization are both principles of accrual accounting. Accrual accounting is different than cash accounting, which only recognizes earnings and expenses at the moment when cash changes hands. Instead, accrual accounting allows a company to spread out the cost of a business expense -- equipment, machinery, intellectual property, even brand names and Internet domain names -- over the life of the investment [source: FinancialWeb].

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Depreciation is used for the purchase of tangible items, like a delivery truck, factory equipment or a laptop computer used for business purposes. Amortization, however, is primarily used for so-called "intangible assets."

Let's look at the example of patents, one of these intangible assets. It costs money to apply for and receive a patent, including the cost of a patent attorney. The legal life of a patent is 17 years [source: Cliffs Notes]. According to Generally Accepted Accounting Principles (GAAP) and section 197 of the U.S. Tax Code, a company can amortize, or spread out the cost of, the patent over those 17 years. So instead of registering one big expense on this year's balance sheet, it can register 17 much smaller expenses on the next 17 balance sheets. The result is that this year's profit will look bigger.

Other common intangible assets are copyrights, trademarks, franchises, brand names, licenses, permits, market share, "non-compete" agreements and something called "goodwill." Goodwill is the accounting term for paying above the fair market value for a good or service. If a company is worth $1 million in assets, but you buy it for $1.2 million because the company has a great reputation, that extra $200,000 is called goodwill and it's an intangible expense that you can amortize on your balance sheet.

For lots more information about mortgages, budgets and business accounting, see the links on the next page.

How Amortization Works: Author’s Note

It's kind of crazy to think that the home mortgage, as we know it, didn't exist until the 1930s. Before that, folks had to throw down a 50 percent down payment and the terms of the home loan were as short as five to seven years. How many of us could afford a home if we had to come up with a check for half of its value just to close? That's why amortization is such a powerful way to make a big, long-term purchase. The monthly payments stay low while you slowly chip away at the principal. Do yourself a favor, though, and never look at the "total interest paid" line on the amortization calculator. It will make you weep like a child.

Sources

  • Cliffsnotes.com. "Intangible Assets" (Accessed Jan. 30, 2011.) http://www.cliffsnotes.com/study_guide/Intangible-Assets.topicArticleId-21081,articleId-21080.html
  • FinancialWeb. "An Introduction to Depreciation and Amortization" (Accessed Jan. 29, 2011.) http://www.finweb.com/investing/an-introduction-to-depreciation-and-amortization.html#5min
  • Harper, Douglas. Online Etymology Dictionary. "Mortgage" (Accessed Jan. 30, 2011.) http://www.etymonline.com/index.php?search=mortgage&searchmode=none
  • U.S. Department of Housing and Urban Development. "The Federal Housing Administration (FHA)" (Accessed Jan. 30, 2011.) http://www.hud.gov/offices/hsg/fhahistory.cfm

Amortization: Cheat Sheet

Stuff you need to know:

  • Amortization is a method for paying off both the principal of a loan and the interest in one fixed monthly payment over a set period of time. Once you set the terms the loan -- the amount you're borrowing, the interest rate and the length of the loan -- you can easily calculate your monthly payment.
  • Amortization of home loans (mortgages) makes buying a home more affordable. The downside is that you pay much more total interest over the length of the loan.
  • Amortization is also a term used in business accounting. In this case amortization refers to the accounting practice of spreading a big expense (loss) over a number of years rather than reporting it all at once.
  • Depreciation is the accounting method for spreading out the expense of "tangible" assets like machinery or vehicles. Amortization is the accounting method for covering "intangible" assets like intellectual property (copyrights, trademarks, brand names), franchises, licenses, and permits.

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