Most people would say that they are responsible with their debts, but there are stressful times when the burden of debts can get the better of us and cripple our finances. When personal debt management starts to become overwhelming, the impact on our physical and mental health becomes very real. Many people suffer from stress, depression and anxiety as a result of unmanageable debt. In the US alone, studies have revealed that 16% of suicides have been in response to a financial problem. Therefore, it’s critical to find effective ways to organize, manage and clear off debts – and amortization is one such way. Here is some useful information about how amortization can help.
- What Is Amortization?
For the regular person, amortization may seem a bit complex as it has to do with numbers. But amortization is a very important accounting tool that everyone can use to successfully pay off their debts in a smart and organized way. Amortization can be leveraged by both individuals and organizations to pay off installment loans and write off assets during a set time period. When properly done, amortization can become a good financial advantage.
Amortization broadly covers business assets and loan repayments. Amortization refers to the process of paying off a loan in sets of fixed amounts within a specified length of time.
For Business
In business, amortization is an accounting technique that is used to principally move assets from a balance sheet onto an income statement. This is done by often writing off intangible assets over the period they are anticipated to be used. Examples of such assets include patents, trademarks, and copyrights.
If a company has an invaluable patent, which is expected to be active for 15 years, if the company spent $15 million to create the patent, the company can make a note of $1 million per annum to be counted as amortization expenditure which can then be included in their income statement.
For Loans
Most people know amortization as the accounting term that refers to the breakdown of the starting balance of a loan, without the principal and interest to be paid with a length of time. The amortization schedule usually makes interest payments higher at the start of the payoff period and gradually decreases during the remainder of the payoff period.
2. Loan Amortization Tips
The first step to quickly pay off your amortized loan is to get rid of the loan itself. Here are a few tips to aid you in that regard.
- When making monthly payments, add more money. Increase your payments by at least $100 and reduce the duration.
- If you do come into some good sum of money, make a lump sum payment and significantly reduce the loan amount.
- Increase the frequency of your payments. Instead of paying monthly, you should consider paying every fortnight. This will decrease the duration and will save you interest payments.
3. Benefits of Amortization
Understanding amortization is the key to knowing how the borrowing system works. Lots of people make decisions depending on how affordable monthly payments are. But interest is the real measure of the cost of what you buy. In most cases, lower monthly payments mean you will pay more interest over a longer period of time. Understanding amortization will also help you to evaluate and compare loan options to find out which one best suits your needs.
4. The Amortization Process In Detail
To comprehend how the amortization process works, the best way to go about it is to study an amortization table. An amortization table is basically a timetable that notes each monthly payment and how much of that payment is divided between the interest and the principal.
On every amortization table you will find the following:
Scheduled Payments
This refers to the monthly payments that you are required to pay every month for the duration of the amortization.
Principal Payment
This is how much of your monthly payment is deducted to pay off the loan principal
Interest Expenses
This is the amount that covers your payment of interest on the loan and it is determined by multiplying your loan balance by the monthly interest rate.
Even though your monthly payment remains the same, each payment will be divided into different amounts to cater for payments on the principal and interest which continue to reduce with time. At the start of the amortization process, you will notice that the interest is at its highest but will continue reducing as more of the consecutive monthly payments will be focused more on the principal.
5. Calculating Loan Amortization
With amortization, the objective is to ensure that total payment is made with the stipulated time while reducing the interest payments and increasing the principal on the loan. The calculation of loan amortization depends on the principal and the interest on the loan.
6. Step by Step Process
You can simply calculate loan amortization in a step by step process. First, you will need to gather all the information on the loan that determined the loan amortization schedule. This means that you will need the payment terms and terms under which the loan was given.
Now let us take a sample mortgage loan and break it down.
Now let’s say we have the outstanding loan which has a principal of $100,00.
Then we have the interest on the loan at 6%
We also have the term of the loan at 30 years or 360 months
The monthly payment is pegged at $599.55
Though the actual loan amount is fixed, the payments you make on the loan with regards to the principal and interest are not, and this is why amortization is a great tool.
To accurately calculate amortization and determine the ideal equilibrium with principal payments vs interest payments, you need to find the debt’s periodic interest rate and multiply it with the original loan balance. The figure you end up with will reflect the amount of interest that is due on a monthly payment. At this juncture, you may subtract the amount you pay for interest from the total loan balance to know how much of the loan payments will cover the principal.
For instance, if you have a mortgage loan worth $240,000 that spans 30 years with an interest rate of 4%. After doing the calculations, your first monthly payment will be $1,146. The periodic interest rate will be 0.33%.
Now, multiply $240,000 by 0.33% and the result will be $792 which is your initial interest rate payment. Subtract the $792 from your first monthly payment of $1,146 and you will have $354. This $354 reflects the amount of your monthly loan repayment that covers the principal on the loan.
Going forward if you want to calculate your amortization rate, use the remaining principal balance of the loan which is $240,000 minus $354 = $239,646 and multiply it again by 0.33% to determine the next interest amount you have to pay. With each monthly payment, just repeat the process to figure out the amortization schedule.
7. Loans that can be Amortized
Not all loans can be amortized. There are several kinds of loans and they all work differently. Only installment loans can be amortized and the total amount will be paid overtime with the monthly payments. Examples of an installment loan are;
Auto Loans
These are easily amortized as they often span a duration of five years or less with fixed monthly payments. There are long periods of amortization for auto loans but you may end up losing as the resale value of the car may be less than the original you took to buy it. You will also end up spending more on interest and become upside-down on your loan if you want to pay less monthly.
Home Loans
These are loans that often span 15 to 30 years with fixed-rate mortgages. With these loans, you have the option of choosing a fixed amortization schedule or an adjustable-rate mortgage. Adjustable-rate mortgages enable the lender to adjust the rate on a pre-arranged schedule which will affect your amortization schedule. The best way to make the most out of this type of loan is if you will stay in the same place for the entire duration of the amortization schedule.
Personal Loans
These are loans that you can easily acquire from several sources such as banks and credit unions. This kind of loan can be easily amortized as well and usually have three-year terms with fixed interest rates and monthly payments.
8. Loans That Cannot be Amortized
Credit Cards
With credit cards, you are eligible to constantly borrow on the card and are free to pay how much you want so long as you exceed the minimum payment. This is often referred to as revolving debt.
Interest-Only Loans
This kind of loan is not exactly amortizable although it can be in the later stages. In the interest-only period, you can only make payments on the principal if you make payments exceeding the interest cost.
Balloon Loans
With this type of loan, you only make small payments in the first few years but in time, you are required to pay a huge sum when the loan duration is due.