Amortization has different meanings in various industries.
In real estate, it is a schedule for your monthly mortgage loan payments which shows how much goes to principal and how much goes to interest.
In accounting terms, it is the process of paying off a debt that has a fixed schedule for repayment with regular monthly payments over a period of time.
In business, amortization happens when a corporation spreads its capital expenses for intangible assets over its useful life for accounting and tax purposes.
How does amortization work?
At the start of the loan, interest costs are at the highest, especially with long-term loans, like a 5-year car loan or 15-year mortgage. At the beginning of the loan, you only pay off a small portion of the total balance, which means that, during the first few years, you’re not making a lot of progress on your repayment. However, a larger portion of your monthly payments will go towards the principal and you pay less in interest every month.
To tie an asset’s cost with the revenue it generates, companies amortize expenses. For example, company A owns a 15-year patent for a piece of technology and spends $15 million to develop the device. Every year, the company will then record on its income statement $1 million as amortization expense.
Types of amortizing loans
Home Loans – Most home loans last 15 to 30 years with fixed interest rates. However, most homeowners sell the property or apply for refinancing at some point.
Auto Loans – Car loans are usually a five-year contract or shorter. These loans also have fixed monthly payments. Stretching out an auto loan to get a lower monthly amortization could put you at risk of being upside-down on your loan.
Personal Loan – These are loans that you can get from a credit union, online lender, or bank, which usually last for three years with fixed interest rates and monthly payments.