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.

Comments

Post a Comment

Popular posts from this blog

Explaining Gilt-edged securities (shortened to gilts)

Gilt-edged securities, also known as gilts, are debt securities issued by the government of the United Kingdom.   They are called gilt-edged securities because they are considered to be among the highest quality and most secure investments available, with a long history of low default rates and stable returns. Gilts are issued in a range of maturities, from short-term bills with a maturity of less than one year, to long-term bonds with a maturity of over 25 years. They pay a fixed rate of interest, known as the coupon, which is paid to investors on a regular basis, typically semi-annually. The principal amount of the gilt is repaid to the investor at the end of the term of the gilt. Gilts are issued by the UK Debt Management Office (DMO), which is an agency of the UK government responsible for managing the government's debt. The DMO issues gilts on behalf of the government to finance its borrowing requirements, and sets the terms and conditions of the gilts, including the coupon ra
Read more

What is Final Consumption Expenditure?

Final consumption expenditure is a measure of the amount of money that is spent on goods and services by households, governments, and nonprofit organizations for the satisfaction of their own needs and wants.  It is one of the main components of GDP, along with gross capital formation (investment) and exports minus imports (net trade). Final consumption expenditure can be divided into two categories: household final consumption expenditure and government final consumption expenditure. Household final consumption expenditure is the money that is spent by households on goods and services for their own consumption, such as food, housing, and healthcare. Government final consumption expenditure is the money that is spent by governments on goods and services, such as education, defense, and public health. Final consumption expenditure is an important measure of economic activity, as it reflects the demand for goods and services by households, governments, and nonprofit organizations. It is
Read more

What are Chained Volume Measures (CVM)?

Chained volume measures (CVM) is a method of adjusting economic data for price changes over time, in order to make the data more comparable and easier to understand. CVM is used to adjust data from different periods for inflation, so that the data can be compared in "real" terms. This means that the data is adjusted for the effects of inflation, so that the comparison between different periods is more meaningful. For example, if we wanted to compare the GDP of a country in two different years, we could simply compare the nominal GDP figures for those years. However, this would not take into account the fact that the general level of prices may have changed between the two years. Inflation would cause the nominal GDP figures to be higher in the later year, even if the actual amount of economic activity had not increased. To correct for this, we can use CVM to adjust the GDP figures for inflation, so that we can compare the "real" GDP of the two years. This will give
Read more