Synopsis: Amortization is a financial concept that helps you understand how your loan is repaid over time. By creating a predictable payment schedule, amortization makes budgeting and financial planning a breeze. This guide will explore how amortization works and learn how to calculate and create amortization schedules.

What Is Amortization?

Ever wonder how loans and intangible assets shrink in value over time? The answer lies in amortization. It’s a financial concept that gradually reduces the recorded value of these assets to help you acknowledge their declining usefulness or repayment progress over time. In the next section, we’ll bring these concepts to life with clear examples to solidify your understanding.

Understanding Amortization of Business Loans

Amortization can be tricky because it has two main uses: for loans and intangible assets.

Let’s take a look at loans first.

Amortization for Loans

Let’s say you have borrowed Rs 10,000 to purchase machinery. As per the loan terms, you must pay back with equal monthly EMIs in 5 years (60 months) at an annual interest rate of 5%. A part of each payment will go towards paying down the principal and the rest towards the interest. Amortization is the process of spreading out loan repayment over time. So, with each payment, a little less goes to interest, and a little more goes to paying off the principal.

Here’s a simplified example:

Loan amount: Rs 10,000

Interest rate: 5% (per year)

Loan term: 5 years (60 months)

An amortization schedule will show exactly how much each payment goes to interest and how much goes to the principal.

For easy math, let’s consider each monthly EMI is an even Rs 200.

• In the beginning, most of that Rs 200 would be interest on the Rs 10,000 loan.
• But as you make payments, the loan amount itself goes down.
• So, over time, a larger portion of that Rs 200 goes to paying off the principal and a smaller portion goes to interest.

This is amortization – spreading out the loan repayment over time.

Amortization for Intangible Assets

Companies own valuable assets that you can’t physically touch. These are called intangible assets, such as trademarks, licenses, and goodwill. They hold significant financial value even though they lack a physical form.

We can categorize intangible assets based on their lifespan:

• Intangible assets with definite life (e.g. license to produce products)
• Intangible assets with an indefinite life (e.g. broadcasting rights of a film)

The former category of intangible assets is subject to amortization and impairment testing (test to acknowledge the permanent reduction in the value of assets). However, intangible assets with indefinite lives are only tested annually for impairment and are not subject to amortization.

How to Calculate Loan Amortization

Understanding how your loan payments are structured can be empowering. Amortization helps us see how each payment contributes to paying off the loan over time. There are two main ways to calculate amortization: using a formula or creating an amortization schedule. We’ll explore the formula method first, followed by the schedule in the next section.

Most spreadsheet programs offer a built-in PMT function for calculating loan amortization. However, understanding the underlying formula is also valuable. Here’s the breakdown:

• Loan amount (P)
• Interest rate (r)
• Number of payments (n)

The formula for calculating the amount per period (A) is shown below:

Let’s say you took a Rs 20,000 machinery loan (P) for 5 years (n = 60 months) at 7.5% annual interest (r). We’ll assume the machine originally cost Rs 21,000 with a Rs 1,000 down payment (irrelevant to amortization calculation).

Step 1: Convert the yearly interest rate into a monthly rate.

So, the interest paid for the 1st month would be:

Since payments are likely monthly, we need to convert the annual interest rate (7.5%) into a monthly rate. We do this by dividing the annual rate by the number of payments per year (typically 12 months).

The monthly interest rate would be 0.075 / 12 = 0.00625

Step 2: Plug the values into the formula.

A = 20,000 * 0.00625 * (1 + 0.00625)^60 / ((1 + 0.00625)^60 – 1)

Using a calculator, you’ll get approximately Rs 400.76 as your monthly payment.

Preparing Amortization Schedules

In the previous section, we learned how to calculate your monthly loan payment. Now, let’s create an amortization schedule, a detailed breakdown of how each payment contributes to paying off your loan over time.

An amortization schedule acts like a roadmap, showing you:

• Total Payment: The amount you pay each month.
• Interest: The portion of your payment that goes towards interest on the remaining loan balance.
• Principal: The portion of your payment that reduces your loan amount.
• Unpaid Balance: The outstanding loan amount after each payment is applied.

Let’s revisit our Rs 20,000 machinery loan with a 7.5% annual interest rate and a 5-year term (60 monthly payments). Here’s a sample amortization schedule for the first few months:

Payment Number	Total Payment	Interest	Principal	Unpaid Balance
				20,000.00
1	400.76	125.00	275.76	19,724.24
2	400.76	123.28	277.48	19,446.76
3	400.76	121.54	279.22	19,167.54
– –	– –	– –	– –	– –
58	400.76	7.42	393.34	793.98
59	400.76	4.96	395.80	398.18
60	400.76	2.49	398.18	0.00

The schedule begins with your original loan amount, which is also called the beginning balance.

In the first month of the payment schedule, you will pay Rs 400.76 as your monthly loan amount.

In our example, with a 7.5% annual interest rate and a Rs 20,000 loan, the monthly interest rate would be 0.075 / 12 = 0.00625. So, for the first month, the interest paid would be:

Interest = Remaining Balance (Rs 20,000) * Monthly Interest Rate (0.00625) = Rs 125

Principal Payment = Total Payment (Rs 400.76) – Interest Paid (Rs 125) = Rs 275.76

Remaining Balance (Month 2) = Remaining Balance (Month 1) – Principal Payment (Month 1)

= Rs 20,000 – Rs 275.76 = Rs 19,724.24

You can repeat these calculations for each month in the amortization schedule. As you make payments, the remaining loan balance decreases; consequently, the interest paid also reduces over time. This reflects the gradual reduction in your loan debt.

Benefits and Disadvantages of Loan Amortization

Benefits of Loan Amortization:

• Predictable payments: The schedule provides fixed monthly payments, making budgeting and financial planning easier.
• Reduced risk: Unlike a lump sum payment, amortization spreads your loan over time to reduce the risk of missed payments due to financial strain.
• Potential interest savings: Consistent payments on amortized loans allow you to pay off the principal faster, reducing the loan interest over time.

Challenges of Loan Amortization:

• Extended Debt: Amortization schedules stretch out loan repayment over a longer period. As you pay interest for a longer period, the total interest will increase compared to shorter loan terms with higher payments.
• Limited flexibility: When you pay fixed payments, your ability to make additional principal payments towards the loan is limited. There could be a penalty for making early payments.

Amortization vs. Depreciation

Depreciation is used for tangible assets with a measurable lifespan, whereas amortization is used for intangible assets with value. The following table clearly explains the difference based on various metrics.

Feature	Amortization	Depreciation
Asset Type	Intangible	Tangible
Examples	Patents, copyrights, trademarks, licenses	Buildings, equipment, vehicle,
Salvage value*	Not applicable	Considered in calculations
Depreciation methods	Typically uses the straight-line method	Multiple methods available (straight-line, double declining balance, etc.)
Accounting impact	Reduces the value of the intangible asset and creates an amortization expense	Reduces the value of the tangible asset and creates a depreciation expense

*Here, salvage value represents the asset’s estimated value at the end of its useful life.

End Thoughts

Amortization plays a crucial role in understanding how your loan repayment unfolds. It’s the process of spreading out the cost of a loan, including principal and interest, over the loan term. This creates a predictable payment schedule and makes budgeting and financial planning easier. In this regard, partnering with a digital loan provider can significantly enhance your loan amortization experience.

For instance, digital lenders often provide user-friendly online portals where you can easily access your amortization schedule and track your loan progress in real-time. Responsible digital lenders, like Protium, also prioritize online communication that allows borrowers to conveniently reach customer support for any questions about their loan or amortization.

FAQs

1.What Is Negative Amortization?

If your monthly payment is insufficient to cover the interest owed, the difference is added to the loan amount and will go up. This is called negative amortization. Some lenders allow you to make a minimum payment that does not cover interest. If you go with that option, you may owe more on the loan amount over time due to negative amortization.

2.What Is a 30-Year Amortization Schedule?

This is a detailed breakdown of how your monthly loan payment on a 30-year-old fixed mortgage is applied over the life of the loan (360 months). The schedule will show how much of the payment goes towards interest on the loan and how much goes towards paying the principal amount.