The amortization of debt financing costs is a way of saying the costs you pay upfront to take out a loan get spread out over the loan's entire term for accounting purposes. Under accounting standards and tax law, this is often necessary for the accounting of a business loan. For a home mortgage, you can often deduct mortgage points, which are effectively prepaid interest, from your taxes the year you pay them.
Debt financing costs can be amortized across the lifespan of a loan in order to develop a reasonable repayment plan for the borrower in question.
How Amortization Works
When you borrow money from a bank or another lender, you normally agree on the principal, meaning the amount being borrowed, the interest rate and the amount of time you'll have to pay the loan back. You may also agree to pay additional costs to take out the loan, particularly for a business loan, including accounting fees, legal expenses or additional fees to the bank.
Under common accounting standards, you treat these fees as if they are being paid out over the life of the loan for the purpose of reporting expenses and paying taxes. For example, if you borrow $100,000, to be paid back over five years, and pay $10,000 in various costs to take out the loan, you will expense this over the life of the loan.
Exploring Amortization Methods
The simplest way to do this is called straight line amortization, and it simply divides the fees by the number of years in the loan, so in this case, you will simply divide $10,000 by the total life of the loan, five years, and be able to expense $2,000 each year.
An alternative method is called the effective interest method, and it ensures that the amount of finance charges expensed each year is a fixed fraction of the remaining principal to be paid on the loan. That can be advantageous for tax purposes since it enables you to deduct more in the early years of the loan, when the principal amount outstanding is larger. It's also required in certain circumstances, such as accounting for bonds.
Mortgage Loans and Points
Ordinary personal loans and car loans generally aren't tax deductible, so you generally don't have to worry about amortization. Mortgage interest payments, on the other hand, are deductible if you itemize your income tax deductions.
In some cases, you can pay a bank issuing a mortgage what are called points, generally referring to a percentage of your loan amount, effectively paying more up front to lower your interest rate later on. These generally don't have to be amortized over the term of the loan and can be deducted from your taxes the year you pay them.
Other costs of taking out the mortgage, such as legal fees, title insurance costs and real estate transfer tax, aren't immediately deductible. Instead, they're added to the effective purchase value of the home, known as its tax basis. When you sell your house, if your situation requires you to have to pay capital gains tax on the difference between the sale price and the tax basis, you can effectively reduce your taxes based on these expenses only when you sell, not while you're in the home or when you buy it.
Certain other fees you might pay to get a mortgage, including appraisal fees, mortgage broker commissions and pest inspection fees, simply aren't deductible at all.
- Internal Revenue Service: Publication 535, Business Expenses
- Internal Revenue Service: Publication 17, Your Federal Taxes
- Accounting Coach: Why Are Loan Costs Amortized?
- Motley Fool: Can I Amortize Debt Financing Costs?
- Investopedia: Amortization
- IRS: Home Mortgage Points
- Nolo: Home Purchase Costs You Can't Deduct or Add to Tax Basis
- Cliff's Notes: Bonds Payable