Amortization is an accounting term, but it plays an important role in many types of consumer loans. For example, if you buy a house or take out a car loan, you’ll need to get familiar with the concept of amortization, which outlines how you’ll be paying off your debt over time.
Amortization also factors into small business accounting because it deals with the cost allocation of intangible assets, like patents. Whether you run a small business or want to take out a personal loan, review the ways amortization might affect your financial life, including when you make your mortgage payments.
What Does Amortization Mean?
For consumer loans like mortgages, amortization schedules are essentially payback schedules that include interest and principal. For businesses, amortization is more of a tax entry because companies are allowed tax deductions for amortization expenses. In both cases, the IRS requires extending an amortization schedule over a fixed period of time, much like straight-line depreciation.
Amortization and Personal Loans
When you finance a car, you agree to pay off the principal amount over time. In exchange, you’ll typically have to pay interest.
Your monthly payment to the bank or finance company will be a combination of principal and interest. Your payback schedule, known as a loan amortization schedule, shows how the total cost of your loan is allocated over time. In an ordinary amortization schedule, the amount of interest you pay over time will decrease and your principal payment will increase until the loan is paid off.
The same structure applies to your home mortgage loan. In a typical, 30-year mortgage amortization schedule, your monthly payment will consist of primarily interest at first. Over time, the amount of principal in your schedule will grow until the balance is paid off.
Related: How to Pay Off Your Mortgage Early
Amortization and Intangible Assets in Business
The IRS requires that most businesses amortize the cost of intangible assets over 15 years. By IRS definition, an intangible asset is “one that you cannot see or touch, but that has value.”
Examples include business books and records, licenses, permits, trademarks, patents, and copyrights. You must hold the intangible assets in connection with your business, and they must be actively engaged in the production of income.
Amortization vs. Depreciation
Depreciation and amortization are essentially two sides of the same coin. Both involve expensing the cost of assets over time.
Amortization, however, is used for intangible assets. Depreciation is used for tangible assets, like machinery and equipment.
Find Out: What Is the Net Worth of a Company?
Accrual Accounting Uses Amortization and Depreciation
Accrual accounting is a method of recording the financial transactions of a business. When you use accrual accounting, you record transactions as they occur instead of when the associated cash changes hands.
For example, sales are recorded when they are invoiced rather than when a customer actually pays. Accrual accounting uses amortization and depreciation because it spreads the cost of assets out as they are used instead of when they are purchased.