Management of loans is important for individuals to maintain a healthy and bright financial future. Much of the economy is spurred on by investments in the forms of loans, which allow people to purchase things like automobiles, homes, or other items. There are not many Americans who do not have some familiarity with loans, as car loans, home mortgages, and educational loans are for many a reality of modern life in the United States. What many may not know is that loans are frequently based on the important principle of amortization.
This concept is not as complicated as it sounds and it may come as a surprise to many just how common they are. These loans serve a number of purposes, including allowing the person or institution taking out the loan to pay back the capital and interest over time. Because we live in a world of commerce and currency, amortized loans have become something so commonplace as to be nearly invisible, much like the glass in all the windows of the buildings around us. They are there, everywhere in fact, but we often do not see them.
What Is Amortization?
Commerce and the currency that facilitates it is something that it is easy to take for granted. We assume, tacitly, that national economies and the ins and outs of our daily lives would naturally be motivated by concerns of currency, trade, and loans. Leaving aside the question of whether a world where all of our thoughts and activities are motivated by commercial concerns is a better or even natural one, which we will leave to the works of Balzac, living in the world today does require some understanding of commerce and how loans play an important role.
Though economies and even trade do not necessarily require loans, this type of investment is a common tool that allows for large-scale economic expansion and the accumulation of wealth. Even in societies where currency existed in one form or another, loans were not always common. At times, they were only used for large, expensive schemes that required a large sum of capital, like overseas trading expeditions or large building projects. Otherwise, expenses for projects or commodities were often paid up front, in total, which naturally limited the scale and frequency of these sorts of transactions.
The Importance of Amortization
Amortization is an important concept to understand because it is a common way to structure loan repayment schemes. The reality of loans is that they are meant to be paid back. Another associated reality, tied to the world of commerce that we live in, is that many businesses would not be able to make the purchases or manage their assets if it were not for this concept.
Amortization allows loans to be paid back with interest over a certain period of time, just like your car note or your home loan. So what is amortization? Amortization, in general, refers to repayment of a loan over a specified period with incremental payments of interest and principal. This repayment is part of a fixed repayment schedule, meaning that incremental changes in principal and interest payment over time are clearly delineated. Technically, amortization can be defined as the lowering of the cost value of an asset incrementally over time. In this case, the asset is the loan.
There is more to amortization than that, but understanding the origin of the term helps to understand how it works. Amortization literally means to kill off, referring in this case to reducing the life of an asset (the loan) incrementally over a period of time: killing it off. It may be strange to some to think of loans as assets, but that is what they are, both to the person granting the loan and to the person receiving it, the grantee.
The Root of Amortization
Amortization as used in modern English comes from the Middle English, amortised, which itself has its origins from French and ultimately in Latin. Think of words like mortal, mortality, morgue, and immortality, which all originate from the Latin word for death. In the context of England at the time this term originates in English, it referred to the ability to alienate property in mortmain, usually to the Church. That is, to transform a real estate or property to inalienable ownership in perpetuity.
Although mortmain has been abolished in most countries today, which means that private property is not inalienable but can be purchased or transferred to someone else, the concept of amortization remains and is perhaps more important now than it was then. Amortization of loans, the incremental repayment of principal and interest over a specified period as part of a repayment schedule, allows men and women to take out loans for common things.
Although the benefits of this type of repayment scheme will be touched on later, it should be clear that a fixed repayment plan allows both the person taking the loan and the institution granting it to have confidence that they all understand the terms of the loan and how the loan will be paid back. Amortization also makes clear how interest and principal will change over time with incremental payments.
In reality, there is one other aspect of amortization that is important. Although the term does refer to the killing off of a loan or asset over time, it also refers to the writing off of an asset’s coast for tax purposes. Therefore, we can summarize amortizing as the following:
Amortization of Loans
Loans are amortized by setting a fixed repayment schedule in which the duration of loan repayment and the set payments are clear. This would naturally involve a loan amount, an interest rate, a set regular payment, and a schedule which makes clear how much of the ordinary payment goes to interest and how much goes to principal. This should not come as a surprise to most people. Typically, when an individual obtains a loan they have an idea of the loan amount, the interest rate, the monthly payment, and the payment period in which the loan is to be paid.
An important part of the amortization of loans is the incremental nature of the payments. In other words, though the monthly (or whatever period) payment may change, there is a change in the amount of payment that is applied to principal versus interest on the loan, incrementally. Most of the monthly payment will be devoted towards interest early on in the life of the loan, while towards the end of the life of the loan nearly all of the payment will be towards principal. At this point, much of the interest amount will have been repaid while payment towards principal has increased incrementally.
Benefits of amortization are to follow, but an important use of amortizing for you may be that it is a scheme that the Internal Revenue Service (IRS) uses to allow taxpayers to write off certain expenses. These are generally intangible assets or expenses encountered as part of the normal operation of a business, like geological expenses in natural gas exploration. This type of amortization highlights the significance of the term as an asset, albeit an intangible one, that can be quantified and written off.
Benefits of Amortization
The benefits of amortization are many. This scheme actually represents a unique example of how a tool used for a different purpose in the past can be modified and used for useful effect in the present. Amortizing not only allows a loan to be repaid over a specified period, to the benefit of the grantor of the loan and the recipient, but this concept also allows certain intangible assets to be written off for tax and accounting purposes. Although the origins of this concept may have been specifically tied up in the inalienable mortmain property of the Middle Ages, the benefits of amortizing have extended to modern times, far beyond the realm of liege lords, peasants, and powerful religious orders.
Amortizing offers benefits to many of the players involved. Some of the benefits of amortizing include:
Loans are, for better or worse, an essential way that businesses and individuals are able to meet their costs and increase their revenue. Amortization, with its origin in real assets of the Middle Ages, is a tool that allows for the repayment of a loan over a fixed period with incremental payments, and for the writing off of an intangible asset as an operational expense during its useful life.
With its unique ability to aid businesses in killing off loans and writing off intangible expenses, there is no reason to believe that amortization of loans will be going anywhere in the near future.