What is Amortization - Definition, Formula, and Importance

In the world of finance, there are many terminologies that can be confusing for the consumer. However, these terminologies help simplify and break down the functioning or underlying characteristics of financial instruments.

Table of Content

• What is Amortization?
• Formula to Calculate Amortization
• Importance of Amortization
• Different Types of Amortization

 Similarly, this is what amortization means: the breakdown of a much larger payment into small payments that seem quite manageable. Are you reluctant to obtain a loan? Understanding amortization and its importance can help eliminate your doubts, or at least this is what the blog attempts to do.

What is Amortization?

Taking a first glance at the payment that you have to make while availing loans can be stressful. This is where amortization comes into the picture. For individuals who have borrowed loans, amortization means monthly EMIs and for businesses, it means a thorough report of expenses. Individuals with a good CIBIL score can avail loans with lower interest rates.

 Even though the payable interest is the cost of borrowing, it indirectly influences the amortization i.e. significant reduction of the principal amount.

As mentioned above, the term amortization is used in two different contexts. Firstly, it is used in situations where companies want a clearer indication of the capital expenses incurred through intangible assets over a specific course of time. Secondly, during a loan amortization, the tenure of the loan help breaks down the repayment amount of the loan into monthly EMIs.

Formula to Calculate Amortization

Imagine you wish to calculate amortization for a patent purchased at Rs. 10,00,000 with its life valued at 10 yrs. The formula to calculate this would be: Purchase Price/Total Life of the Asset = Amortization Per Year. By putting the values, we get the amortization for the patent as Rs. 1,00,000.

Whereas the formula for loan amortization is: A = [i x P x (1 + i)n] / [(1 + i)n -1]

Where,

A = Periodic Payment Amount

P = Principal Amount 

i = Rate of Interest

n = Total Number of Payments

To make it simple, you can use a loan amortization calculator.

Importance of Amortization

• Amortization is essential because it assists both businesses and individuals in understanding and managing their cash flows. Under the circumstances of loan repayment, the breakup of payments that are scheduled according to the loan tenure gives clarity to the borrower regarding the interest and principal costs.
• Amortization of loan interest and the costs of intangible assets come with tax benefits, such as reducing the taxable income.
• Amortizing intangible assets is important as it can reduce the taxable income of a business or an individual. This eventually helps an investor understand what they have earned.

Suggested Read: What is the Interest Coverage Ratio and Why is it Important?

Different Types of Amortization

Amortization is a payment structure associated with clearing the debts and pending dues. There are many ways to structure this payment, such as:

Fixed-Rate Amortization

Borrowers in this payment method pay a fixed amount throughout the tenure that includes both interest and principal amount. Here, the interest rates are fixed.

Variable-Rate Amortization

Generally, a proportion of loans is amortized at a variable interest rate initially. After which, the amount depends on the fluctuating interest rates.

Deferred-Rate Amortization

These are applicable in residential housing loans. The amortization schedule is designed in such a way that most of the interest due on the loan amount is paid during the initial stage of the loan.

Suggested Read: Financial Leverage Explained: Types, Formulas & Examples

Negative Amortization

This type of loan amortization does not cover the entire interest payment. For this reason, the initial principal interest due keeps increasing with time. However, they are ideal for flexible repayments.

Individuals can obtain a personal loan from Muthoot Finance through a straightforward and hassle-free process. If you are looking for unsecured loans, clarify your concerns from our experts at a Muthoot Finance branch near you.