Amortization explained in simple terms

You may have heard the term 'Amortization' or been asked to consider it, but what exactly does it mean?


Essentially, Amortization is the process of spreading out the cost of an asset, such as a loan or an intangible asset, over a period of time. 

This is typically done through a series of equal payments, called amortization payments, which are made on a regular basis, such as monthly or annually. Each amortization payment consists of a portion of the principal amount of the loan or asset, plus interest.

For example, if you take out a £100,000 loan with a 10% interest rate and a 10-year repayment period, your monthly amortization payment would be £1,073.64, which would consist of £869.62 in principal and £204.02 in interest. Over the course of the loan, you would make a total of 120 amortization payments, and you would pay a total of £128,437.68, which would include £100,000 in principal and £28,437.68 in interest.

The advantage of amortization is that it allows the cost of an asset to be spread out over time, making it more affordable and manageable. For example, if you were to buy a £100,000 house with a 30-year mortgage, your monthly amortization payment would be much lower than if you were to pay for the house in one lump sum. This makes it possible for people to buy assets that they might not otherwise be able to afford.

Amortization can also be used to gradually write off the cost of intangible assets, such as patents or copyrights, over their useful life. For example, if a company spends £100,000 to develop a new software program, it could amortize the cost of the program over a period of 10 years, which is the estimated useful life of the software. This means that the company would expense £10,000 of the cost of the program each year, which would reduce its taxable income and, in turn, its tax liability.

In addition to making assets more affordable and manageable, amortization can also help to smooth out the cash flows of a business or an individual. For example, if a company has a large upfront cost for a new asset, such as a factory or a piece of equipment, it can use amortization to spread the cost out over time, which can help to ensure that it has a steady and predictable stream of cash inflows and outflows.

Overall, amortization is a useful tool for managing the cost of assets, such as loans and intangible assets. It allows the cost of an asset to be spread out over time, making it more affordable and manageable, and it can help to smooth out cash flows.

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