Amortization

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What is amortization?

Amortization is a way of paying off a debt by spreading payments over a period of time. Payments are divided into equal amounts for the duration of the loan, making it the simplest repayment model.

You are likely to have it when dealing with:

  • Mortgage payments
  • Car loans

How is it calculated?

  • A = periodic amortization payment
  • P = principal amount borrowed
  • r = periodic interest rate divided by 1,200
  • n = total number of payments

For example, if you borrowed $100,000 at an interest rate of 10% and you wanted to make 60 total payments, your periodic amortization payment would be . . .

You would make a payment of $2,125 every month for five years to pay off your loan.

What is an amortization schedule?

It is a table that shows how much each payment will be and over how long a period to pay back the loan. It is usually a blend of payments for the actual loan amount and the interest owed.

Amortization Table

Components

Beginning balance: how much you have left to pay at the beginning of the year

Interest: how much you pay toward interest

Principal: how much you pay toward the principal amount

Ending Balance: how much you have left to pay at the end of the year

An amortization payment consists of a payment applied to both the interest and principal balance of a loan.


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Initially, a large portion of each payment is devoted to interest. Over time, larger portions go toward paying down the principal.

This is the schedule for the previous example of a principal amount of $100,000 at an interest rate of 10% over five years.
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Amortization vs. Depreciation

Amortization: used with intangible assets, such as goodwill, copyrights, and patents

Depreciation: used when dealing with tangible assets, such as buildings, machinery, and equipment

Fun facts:

  • The word “amortization” comes from Middle English “amortisen,” meaning to kill or alienate and from the Latin words “ad” and “mort,” meaning death.
  • There is such a thing as Negative amortization when you don’t pay interest on the loan, so the amount you owe actually goes up instead of down.
  • The most popular period of amortization in Canada is 25 years. About three-quarters of Canadians who have a mortgage have selected a 25-year amortization.

 

References

  1. https://en.wikipedia.org/wiki/Amortization
  2. http:// www.discoveryfinance.com/useful-facts-about-home-mortgage.html
  3. http:// www.mortgagerates.ca/mortgage-help/mortgage-term-vs-amortization

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