Amortisation allows finance professionals to evaluate the changes in the value of income statements and debts. A good understanding of this topic can be helpful in choosing the best loan options and paying off debt faster. Understanding how this process works can help you make smarter financial decisions when considering a loan. In this article, we define amortisation, explain how it works and provide a detailed example.
What is amortisation?
Amortisation is an accounting term that refers to the practice of reducing the monetary value of a loan or an intangible asset over a specific period of time. This process can be helpful in paying off a loan in a specific period. With the help of this accounting method, you can calculate principal and interest rates. You can also use this process to distribute the cost of intangible assets such as trademarks throughout its life.
Two common applications of amortising in finance are reducing the current balance on home, auto or personal loans and outspreading the cost of copyrights, patents and trademarks over a specific period. You can use your knowledge of amortising to repay debts in regular instalments.
What is an amortisation schedule?
It is a schedule that the lender gives to break down the loan and list the cost of payments on a loan as per its maturity date. This schedule can be helpful in ensuring regular payments on time. Lenders such as banks or financial institutions may give the borrower a document comprising necessary information about the loan. This document may include principal payment, interest payment, amount of total interest paid and unpaid loan balance.
With the help of this schedule, you can determine the amount you require to pay each period. In general, scheduling amortised loans may help you focus more on interest in the beginning. This scheduling may continue until the loan balance reaches zero. Scheduling amortised loans can provide you with an understanding of how much you owe in each billing cycle.
How does amortising work?
The process of amortising is useful in distributing the loan amount into multiple scheduled payments. As you pay the outstanding principal amount, the parts of the payment may change. For long-term loans, interest costs can be more costly at the beginning. At the start of a loan, most of the payment may go towards interest expenses.
Only a small part of the payment may get added to the principal balance. Due to this, there can be less reduction in the principal repayment at the beginning of the loan payments. As time passes, more of your money may go into the principal balance. Amortising a loan can help you pay the total loan amount within a certain period. The process of amortising a loan may involve organising monthly payments at a fixed rate over a specific term.
Benefits of amortising loans and assets
Amortising can help you understand how loans work. Finance professionals can use this process to evaluate the amount a company is paying in interest and toward the principal. Here are other benefits of amortising loans and intangible assets:
Monitoring payments
Amortising loans can help you monitor and track your payments. You can calculate the unpaid loan amount and create a chart to monitor your future payments. Amortising can also help in evaluating the accurate percentage of interest and principal from your payments. This process can provide you with the necessary information to pay the right monthly payments on loans. You can plan out your payments and maintain your finances efficiently. Amortising loans can also help you avoid issues like inaccuracy or missed payments.
Comparing loan options
By amortising loans, you can compare various loan options and make the right financial decision. You can calculate the interest and amount you require to pay on each type of loan. This can help you determine which loan provides you with the best payment option. For example, if you are deciding between two loan options with the same interest rate while organising a personal loan then amortising each can help you make an informed decision. You can evaluate the financial situation and analyse if making small or large payments is more desirable.
Adjusting timeline
When you amortise a loan, you get an idea of how much you owe each month. It can help you adjust your payment timeline. By adjusting the payment timeline, you can pay off the loan sooner and save money by reducing the amount of interest. For example, if a borrower requires to pay a monthly loan payment of ₹10,000, they may pay an extra ₹2,000 to reduce the outstanding balance.
Steps to calculate amortising loans
Here are the steps to calculate amortising loans:
- Gather information: Determine the principal amount, loan duration and interest rate.
- Create a table: You can create a table with four columns representing the month, principal amount, interest payment and principal payment.Â
- Calculate monthly payment: You can calculate monthly interest payment by multiplying principal by rate per month.
- Determine the payment for the second month: Repeat the steps to calculate the interest and principal amount for the second month.Â
Example of amortising a loan
Here is a good example of amortising a loan:
Sushant organises a personal loan for ₹1,00,000 at a 9% interest rate over a period of 3 years. He creates an amortisation chart and begins by calculating the number of months the amortising may take.
3 years x 12 months per year = 36 months
He then adds 36 rows to the chart. The principal for the first month is ₹1,00,000 as this is the total amount he requires to pay back.
He converts the 9% per year interest to a monthly interest rate:
9% ÷ 12 months per year = 0.0075
After this, he calculates the interest per month he requires to pay for the current principal:
₹1,00,000 x 0.0075 = ₹750 per month interest
He determines the minimum amount to pay each month toward the principal to complete it in three years. He divides the principal by the total number of months in the loan period:
₹1,00,000 ÷ 36 = ₹2778
After this calculation, the first month in the chart may look like this:
- Month: 1
- Principal: ₹1,00,000
- Interest payment: ₹750
- Principal payment: ₹2778
To calculate the next month, he adds the interest and principal payments and then subtracts the sum from the principal:
₹1,00,000 – (₹750 + ₹2778) = ₹96,472
This amount becomes the new principal for the second month.
Steps to calculate amortising intangible assets
Here are the steps to determine amortising intangible assets:
- Determine the basis value: It is the amount you paid to obtain the asset.Â
- Find the residual value: It is the amount at the end of the usefulness of an asset.Â
- Divide the value by remaining period: You can divide the value of an intangible asset by the years of its useful life.Â
- Record the value of asset: You can record the value of asset on your income statement.Â
Example of amortising intangible assets
Here is a good example of amortising intangible assets:
Shweta buys a patent for a machine for ₹1,00,000. This patent is only useful for five years. She records an asset of ₹1,00,000 for the patent on the income statement. After the completion of the usefulness of the patent, Shweta is unable to sell or generate profit from the patent. This results in the ₹0 residual value of the patent.
She divides the patent value by its useful years:
₹1,00,000 ÷ 5 = ₹20,000
After one year, the income statement of Shweta may look like this:
Assets
Patent: ₹1,00,000
Accumulated amortisation: -₹20,000
Net asset value: ₹80,000
