Amortization is derived from the Middle English word amortisen, meaning ‘to kill’. In finance, it means the killing off of liabilities! This may be done by spreading payments or the gradual elimination of a liability over a specific period of time. Most often, it has two distinct uses, which are the amortization of loans and the amortization of intangible assets.
Amortization of Loans
When talking about loans, amortization refers to the distribution of repayment into multiple cash flow instalments. Unlike the repayment schedule on some forms of liability (ie. a bond, where only interest is paid over a debt’s lifecycle and the principal is re-paid at the end of a borrowing term, when a liability is amortised each repayment consists of both interest and principle. If a liability is “fully amortized” into even repayments, then with the last repayment instalment, the debt-holder will have paid off everything they owe. Mortgages are the most commonly amortized liability.
The Fluent Financier Amortization Calculator will work out the monthly, yearly and total repayments of a debt or liability (ie. a mortgage), given the amount you need to borrow.
Amortization of Intangible Assets
Amortization also refers to the accounting concept of writing off the value of an intangible asset as an expense to the income statement over time for reporting and tax purposes. As well as amortizing intangible assets like goodwill, it is also common to amortize the premium over par value paid for any preferred stock or bond investments to reflect the change in their resale value. Amortization is essentially the same concept as depreciation, the difference being that depreciation refers to the reduction in value of fixed assets over time while amortization refers to intangible assets.
An example of amortization would be the gradual writing off of a patent. Say that company X defies the laws of chemistry, creating an incredible new way to turn copper into gold and acquires a patent for this process, costing them £50,000. Now take the lesser of the patent’s economic life (the length of time you expect the patent to be useful and bring in revenue for the company) and its legal life (the time until the patent expires), which we’ll say is 10 years. Simply divide the £50,000 by 10 to work out the annual amortization of the patent. Each year, we would expense £5,000 to the income statement under the depreciation & amortization ledger, which comes before interest expenses and tax, while simultaneously writing off £5,000 from the balance sheet under intangible assets or more specifically patents.
Did you find this amortization definition helpful? Subscribe to our spam-free newsletter to receive regular financial definitions, updates on our latest articles, plus exclusive annotated market reports.