Amortization is a process through which the cost of an intangible asset is gradually expensed or paid off over a specific timeframe. The most common examples of such assets include patents and trademarks. This method is often used in lending scenarios where a loan or a mortgage is gradually repaid over a certain period. Each payment covers a part of the interest and principal, aiming at entirely offsetting the loan by the end of its term.
1. What’s the benefit of amortization?
Amortization helps businesses spread out large costs over many periods, reducing the potential financial burden. It also offers individuals a way to gradually pay off loans, including large amounts such as mortgages, over time, making them more manageable.
2. How does an amortization schedule work?
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An amortization schedule breaks down each loan payment into parts for principal and interest. At the start of the loan repayment, the interest portion of each payment is higher, but as the principal shrinks with each payment, less interest accrues, and more of your payment goes toward the principal.
3. What’s the difference between amortization and depreciation?
While both amortization and depreciation spread out costs over time, they apply to different types of assets. Amortization relates to intangible assets like patents or trademarks, while depreciation applies to tangible assets such as machinery or vehicles.
4. Can amortization apply to any type of loan?
Amortization is commonly used for fixed-term loans, which include mortgages or car loans. It doesn’t apply to revolving credit like credit cards, as these don’t have a fixed repayment schedule and are repaid at the discretion of the borrower.
5. Are there any drawbacks to amortization?
One potential drawback to amortization is that it can make a loan seem more affordable at the outset but can lead to paying a significant amount in interest over the life of the loan. Borrowers may pay more than twice the original loan amount in interest if the term is long.