What is amortization?
Amortization is a financial term referring to the process of paying off debt over time in equal amounts. It is most commonly used when referring to the repayment of a loan, where amortization is the gradual reduction of debt through regular payments of principal and interest.
When it comes to loan amortization, an individual or business will typically make predetermined payments at regularly scheduled intervals over a specified period of time.
How to calculate amortization?
A= P [i (1+i)^n/(1+i)^n-1]
The first step in calculating amortization is determining the periodic payment amount. This is done by taking the loan's principal balance multiplied by the periodic interest rate (annual rate divided by 12) and then adding this result to 1 raised to the power of n times -1, where n is equal to the number of periods (term length multiplied by 12). The answer will be divided by 1 minus that same result as before.
The next step is figuring out how much of each payment goes toward principal versus interest. To do this, take the principal balance and multiply it by the periodic interest rate. This calculation can be done for each individual period throughout the loan's term.
The final step in calculating amortization involves subtracting the interest from each payment from what was originally calculated in Step 1 and then subtracting that result from what had been previously calculated for both steps 1 and 2; this will give you your total amount for repayment for that particular period. This process should be repeated for each remaining period until completion.
Amortization vs Depreciation
The most notable difference between amortization and depreciation is that amortization applies to intangible assets while depreciation applies to tangible assets. Another key distinction between them is how they're reported on an income statement. Amortization expenses are reported within operating expenses while depreciation expenses are typically recorded under cost of goods sold (COGS) or as a separate line item on the income statement.