Amortization is a term used by accountants and financial officers to apply time concepts to account-based financial statements. You most often here this term when working with interest payments or loan calculations. Amortization has a long history and use in many areas of finance. Because of this there are many types and time spans applied to the term. There are also misconceptions. Here is a brief overview of what amortization is and how it functions in the financial world.
Amortization is defined as an act or process of amortizing. It is a principle of accounting similar to depreciation where it gradually reduces the value of an asset or liability over time via payments.
For a tangible asset this process spans the useful life of the item. For liabilities, amortization covers a set period of time where the money is repaid. In this way a portion of known income is allocated to the life of the loan repayment.
The one serious misconception about amortization is the confusion between amortization and depreciation. Depreciation is mainly used in regard to tangible assets such as buildings, vehicles, machinery or property. Amortization is mainly used in regard to intangible assets such as copyrights, patents or product development costs.
With regards to liability, amortization differs from depreciation in that amortization deals with future income distributed over time. Depreciation deals with the loss of income over time.
The word “amortization” is brought down through history from the Middle English word amortisen meaning to kill or alienate; from the Anglo-French word amorteser which is an altered version of amortir also meaning “to kill”; and from the Latin admortire which combines both the words “ad” “plus “mort” meaning “mors death”. It also has connections to the word mortgage through this line.
There are different uses, or types, of amortization depending on the use of the accounting method. There is business amortization which is the allocating of specific amounts to different time periods as in loans or other borrowed funding. Amortization analysis is the method of analyzing the cost of execution over a set of operations With tax law, amortization refers to the amount of interest paid over time in regards to tax rates and payments. The term also has a use within zoning regulations as it describes the time that a property owner has to relocate because of a preexisting use under zoning guidelines. The term “Negative Amortization” applies to loan amounts that increase when the full interest amount is not paid in a given time.
The time period which amortization is in effect can vary greatly. This period can stretch from just over a year to up to 40 years depending on the asset being used and the type of loan. Examples of this would be the costs of establishing patent rights which usually last 17 years; or a building loan which can last up to 40 years; or an automobile loan which normally lasts for only five years.
While this effect holds true for most tangible assets, some items such as land and trademarks have an indefinite life span and can actually increase in value over time therefore making themselves not subject to amortization.