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If you're taking out a loan — perhaps a small business loan, a mortgage or a loan for your car — it's important to understand the definition of amortization. Amortization also comes into play with intangible assets tied to your small business. In this guide, we'll go over exactly what amortization is, how it works with loans and business assets both tangible and intangible and what to keep in mind with amortization when taking out a loan.
What Is Amortization?
In a nutshell, amortization is the process of paying off a loan by making regular, fixed payments. Over time, the amount you owe on the loan goes down, and you continue making payments until the loan is paid off.There are two main parts of loan amortization: a principal amount and an interest amount. How much of your regular payment will go toward principal and interest will differ each month, which we’ll discuss in greater detail below.
In Real Estate
Amortization is likely one of many various mortgage terms you’ve come across. When you take out a mortgage to buy property, your loan is on an amortization schedule, which can show you how much of your monthly payment is going toward the principal and how much goes toward interest.With amortization, the amount you pay each month is the same. However, how much goes toward interest and how much goes toward the principal changes. At the start of your mortgage, more of your payment is put toward the interest, and less toward the interest. And toward the end of your mortgage term, the reverse is true: most of your payment goes toward the principal, and a little goes toward the interest. When a loan is fully amortized, you don't owe anything after making all your payments by the amortization schedule.
In Business
You might've heard of depreciation when it comes to a business's assets, and amortization is another way to determine the value of an asset over a length of time. It might be a bit confusing, as amortization with a loan versus amortization with a business's assets are entirely different things. We'll look in greater detail at how amortization is used to gauge a business's assets in just a bit. Despite the different meaning of amortization in the business world, when it comes to taking out a small business loan, you're looking at an installment loan with a fixed payment schedule where you're paying into the principal and on interest — in other words, the first definition of amortization. Keep in mind, however, that whether amortization applies depends on which of the types of business loans it is.
How Does Amortization Work?
As mentioned before, amortization differs depending on whether it applies to loans or to intangible assets for a business. Here’s how amortization works in both situations.
Loans
With an installment loan — think a car loan, student loans, a mortgage, a personal loan or a small business loan — you're on an amortization schedule. This schedule shows how much of your monthly payment is going toward the principal balance and how much is going toward interest fees. You're on a fixed payment schedule, so the amount you pay each month doesn't change. With car loan amortization, for instance, when the loan is fully amortized, that means that you won't owe any payments once the loan ends. Positive amortization is when you're making payments on your principal, so the amount you owe steadily decreases over time. Negative amortization, on the other hand, is when your payments aren't enough to cover the interest. In turn, the amount you owe increases over time.
Assets
Amortization is used to figure out the cost of an intangible asset over the course of its useful life. Examples of intangible assets might be intellectual property, such as copyrights, trademarks and patents; proprietary processes and valuable information and data; and computer software. Unlike tangible assets (i.e., business equipment, supplies), intangible assets don't usually have any resale value. The process of amortization here works like so: The residual value of the intangible asset is subtracted from the cost, then divided by the useful life of the asset.The intangible asset’s cost is typically the same amount for each period of time. Getting into the weeds, the IRS allows intangible assets to be amortized for a 15-year period, as long as it's included in Section 197. Each year, as a business you can deduct the value of the asset from your balance sheet. In turn, it can lower your tax burden and how much you owe on taxes.
Pros and Cons of Amortization
As with most things, there are benefits and drawbacks to amortization. The pros and cons vary depending on whether it’s business loan or mortgage amortization.Pros of Loan Amortization:
Set payments: A major advantage of an amortized loan is that, with a fixed-rate loan, you know exactly how much you'll be paying each month.
Clear payment schedule: The payment schedule is pretty straightforward. For instance, your repayment schedule might be for five years, and you'll owe $500 each month.
Cons of Loan Amortization:
You don't build equity at the beginning: Because most of your payment will be going toward interest when you start making payments and less toward the principal, you aren't building a lot of equity from the get-go. It's only over time that you'll gradually build more equity.
Hard to see how much you're actually paying on a loan: With loan amortization, it might be hard to see exactly how much you're paying in interest fees over the course of the loan. You'll need to look at an amortization schedule to see how much of each payment is going toward the principal and how much is going toward the interest fees. Then, you can do some simple math to see how much you're paying in interest.
Pros of Amortization of Assets:
Can lower taxes: A major benefit of amortizing intangible assets is that it can lower your business’s tax burden, which translates to smart cash management for businesses.
Can show higher income: Amortization can also show that your assets are worth more and that you have more income. This could come in handy if you are seeking more capital to grow your business, either from investors or in the business loan application process. It can also help you see more clearly what your business's earnings are.
Cons of Amortization of Assets:
Can be difficult to gauge the useful life of an intangible asset: It might be hard to figure out exactly how long an intangible asset might be useful for. For instance, computer software might end up being obsolete, or a license to a digital asset might not be as integral to a business's operations and success as initially anticipated. So while it may have been anticipated that the useful life of a license to a media property would be four years, it could end up being closer to one year.
Can be difficult to figure out the costs of an intangible asset: Unlike a physical asset, such as a building or manufacturing equipment, it can be challenging to figure out the actual cost of an intangible asset.
What Can Be Amortized?
As mentioned, amortization applies to loans and assets — but only certain types can be amortized.
Loans
Most installment loans can be amortized. That's because there's a set length of the loan term and fixed monthly payments. Examples of loans that can be amortized include student loans, personal loans, small business loans, mortgages and car loans.
Assets
Only intangible assets with a set legal or useful life can be amortized. For instance, maybe a patent is set to expire after 20 years, or a trademark has to be renewed every 10 years. Or computer software might not be considered proprietary by the company that created it after five years.
What Can't Be Amortized?
Not every loan or asset can be amortized. Here’s when amortization doesn’t apply.
Loans
Loans that can't be amortized include those that don't have fixed monthly payments, such as home equity loans or balloon loans. Revolving debt, such as credit cards, personal lines of credit and home equity lines of credit, also cannot be amortized.
Assets
Intangible assets that have an indefinite life, such as goodwill, cannot be amortized. Additionally, physical assets, such as tools, vehicles, equipment, machinery, buildings and land, cannot be amortized. To determine the value of physical assets, depreciation is typically used (here’s a rundown on the differences between depreciation vs. amortization if you’re curious).
Amortization Example
Let's take a look at an example of amortization of an intangible asset: Let’s say your small business has proprietary software that's valued at $100,000. As the patent can be used for the business for 10 years, that's the period of time over which it amortizes. Over those 10 years, your business will amortize the expense of $100,000 on the said patent. In other words, your business can deduct $10,000 from the value of the patent — the asset cost divided by its useful life — on your balance sheet each year until the asset’s value goes to zero.
The Takeaway
Loan amortization and amortization of a business's intangible assets are two very different things. In the case of a loan, it can help you see when you can expect the loan to be paid off through regular, fixed payments, as well as how much you’ll be paying toward the principal and interest each month. If you’re looking for financing as a small business and are applying for a small business loan, on the other hand, amortizing intangible assets can help boost your income or show that your business assets are more valuable, which could help you qualify for a loan.For those in the market for a small business loan, SoFi makes it easy to compare small business loan rates. Simply apply — with no fee, obligation or impact to your credit — and you’ll be able to see your financing options from our network of lenders.
Frequently Asked Questions
What does amortization mean in property investment?
What is amortization in simple words?
Which assets can be amortized?
Photo credit: iStock/Chaay_Tee
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About the Author
Jackie Lam
Jackie Lam is a freelance writer with experience covering small business, budgeting, freelancing and money, and personal finance. She has written for more than 60 outlets, including Salon.com, CNET, BuzzFeed, Business Insider, and Time's NextAdvisor. She is currently working on her AFC® financial coaching certification to help artists, freelancers, and small businesses.
