In business accounting, amortization refers to the process of making multiple payments over a period of time. A common example of amortization is a mortgage. Rather than buying 100% of the home’s cost, the homeowner typically takes out a mortgage, which he or she may pay on a monthly basis according to the lender’s terms. However, there are two specific types of amortization used in accounting: amortization of loans and amortization of assets. To learn more about the nuances between these types, keep reading.
Amortization of Loans
As the name suggests, amortization of loans involves the distribution of partial payments over a period of time. The repayment schedule is defined by the amortization, with each payment installment including both principle and interest. The total cost of the purchased product or service is divided into equal amounts by the amount of payments the business/borrower is expected to make. This means the borrower pays the same amount every time he or she makes a payment towards the loan. Because of the simplicity of this repayment model, it’s become the preferred choice among lenders and borrowers alike.
It’s important to note that negative amortization can occur if the borrower’s payments fail to cover the interest of his or her loan. The unpaid interest is added to the outstanding balance of the loan, which subsequently makes it larger than the loan’s original amount. Assuming the borrower pays according to schedule, however, negative amortization shouldn’t occur.
Amortization of Assets
In addition to loans, there’s also amortization of assets. Amortization of assets involves the value decrease of an asset over a period of time. It’s not uncommon for tangible assets to lose value over time. Known as depreciation, this typically occurs to computers, cars, heavy machinery and equipment. Business owners who own assets that depreciate in value must account for that depreciation accordingly, which is where amortization of assets comes into play.
Additionally, amortization can occur to intangible assets. Amortization of intangible is calculated by taking the initial cost of the asset and subtracting that number by the asset’s residential value systemically. When done correctly, this allows business owners to see the financial health of their assets and whether an asset’s value has increased or decreased.
After reading this, you should have a better understanding of amortization and how it relates to business accounting.
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