What Is Amortization?
Amortization refers to the accounting technique which, in use, periodically lowers the book value of a loan or intangible asset over a period of time towards a set maturity date. When specifically used in the accounting of loan transactions, amortization focuses on how loan payments are spread out over time. In regards to an intangible asset, amortization is not too different from depreciation.
Amortization in Commercial Real Estate
When it comes to commercial real estate, the definition of amortization that applies is the one concerning the process of paying off debt through regular principal and interest payments over time. Most loan payments are made in installments, which are equal payments made at regular intervals (Monthly, annually, etc.) comprising both an interest portion and a principal portion. Many mortgage payment calculators include an amortization schedule (visualized in a table format) to help the borrower see a breakdown of interest and principal in each payment as the loan matures. Loans are typically structured to collect more interest at the beginning of the loan and very little of the principal, with each recurring month lessening the interest portion and growing the principal portion. So an amortization table gives a visual representation of this by showing each monthly loan payment total, how much of each payment goes to interest, and how much of each payment goes to the principal. Every amortization table for loan transactions presents the same categories of information:
- Monthly payments: The total value of the monthly payments listed individually by month for the duration of the loan term.
- Interest Portion: Calculated by multiplying the remaining loan balance by the monthly interest rate, each monthly payment contains a portion solely contributing towards the payment of interest.
- Principal Portion: After interest charges are applied, the remainder of the monthly payment goes toward paying down the principal.
Most modern financial calculators and spreadsheet software Are able to calculate and display an amortization schedule. Better still, most online mortgage calculators come with an amortization schedule built right in.
Amortization is a simple enough concept. These amortization schedules start with the outstanding loan balance. Each consecutive row is calculated as follows: the interest portion of each payment is calculated by multiplying the interest rate on the note by the outstanding loan balance. The result is then divided by 12. The principal portion due is the total monthly payment (a predetermined flat amount) less the interest payment for that month. Every month after utilizes the previous month’s outstanding balance minus the most recent principal payment as its own outstanding loan balance for the amortization formula. The new (and smaller) interest payment is calculated using this new outstanding balance, and the pattern repeats until the loan balance is zero at the end of the loan term.
The formula to calculate the amortized monthly principal due on a loan is as follows:
- A = periodic payment amount
- P = amount of principal, net of initial payments
- i = periodic interest rate
- n = total number of payments
What is the difference between a fixed-rate and adjustable-rate amortization?
The main difference between a fixed-rate and adjustable-rate amortization is that with a fixed-rate loan, the interest rate remains the same throughout the life of the loan. This means that the monthly payments will remain the same, and the borrower will not be exposed to sudden changes in the economy. With an adjustable-rate loan, the interest rate can change over time, which can lead to higher monthly payments.
In a healthy economic environment — where interest rates are expected to decrease — variable-rate loans usually cost less to borrowers over the long term, however, this is not the case now. In an attempt to curb inflation, the Federal Reserve has been steadily and rapidly increasing the federal funds rate, which has had significant impacts on those with adjustable-rate loans — and on anyone looking to refinance. Therefore, it is without a doubt that fixed-rate loans are the best financing option when interest rates are predicted to rise significantly.
How does amortization affect the total cost of a loan?
Amortization can affect the total cost of a loan in a few ways. First, amortization can make it difficult to pay off a loan early, as most amortized loans carry long loan terms. Additionally, if a borrower makes a large payment on the principal of the loan, the lender will miss out on the interest that would have been earned on that payment. Finally, amortization can make it difficult to sell a loan, as the buyer will be assuming the remaining interest payments on the loan.
For more information, please see this article.
What are the benefits of amortizing a loan?
Amortization has a number of advantages, both for borrowers and lenders alike.
For borrowers, amortization makes it much easier to budget for loan payments. With a fixed payment each month, borrowers know exactly how much they need to set aside to make a payment. This can make managing finances a breeze and keep borrowers current on their loans.
Amortization can also save borrowers money in the long run. With each payment, both the principal and the interest are paid down. This means that the interest portion of your payment will decrease over time, leaving more of your payment to go toward the principal. This actually can save a borrower a significant amount of money over the life of the loan.
For lenders, amortization provides a steady stream of income. With each payment, the borrower will be paying down both the principal and the interest. Amortization allows the lender to receive interest payments throughout the life of the loan.
Amortization can also help lenders manage their risk. With a fixed payment due each month, lenders can be more confident that they will receive their payments on time. This predictability can help lenders plan for their own expenses and manage their own finances.
What are the risks associated with amortizing a loan?
The main risk associated with amortizing a loan is that it can make it difficult to pay off the loan early. Amortized loans are carefully calculated to balance the amounts paid towards the loan’s interest and principal over a long term — meaning most amortized loans carry long loan terms. Additionally, in order to make extra payments on the principal of the loan in order to pay it off sooner, a borrower would need to calculate the amount of the payment that will go toward the principal. Without prior knowledge of how each payment is broken down, this can be a complex process.
For lenders, the amortization can result in a loss of income if the borrower prepays the loan. If the borrower makes a large payment on the principal of the loan, the lender will miss out on the interest that would have been earned on that payment.
In some cases, loans may be negatively amortizing. In this case, a borrower isn't even fully paying the interest on the loan. Negatively amortizing loans can be particularly risky for borrowers, since each time a borrower doesn't fully pay off a month's interest, that unpaid interest is added to the principal of the loan. The next month, the borrower is required to make a larger interest payment on the new, increased principal. In this case, compound interest actually works against them. In the long run, this can become extremely expensive.
How can I calculate the amortization schedule for an apartment loan?
The Apartment Mortgage Calculator on Apartment.loans can help you calculate the amortization schedule for an apartment loan. All you need to do is input the loan amount and interest rate, then set the amortization and term length to see the expected monthly payment figure over time. Additionally, the Amortization post on Apartment.loans explains that most modern financial calculators and spreadsheet software are able to calculate and display an amortization schedule. Better still, most online mortgage calculators come with an amortization schedule built right in.