Have you ever wondered how banks and financial institutions calculate the repayment of loans on intangible assets such as copyrights, patents and trademarks that you own? You might have come across the term "amortization" while going through your loan agreement or while calculating your monthly payments. Keep reading to learn more about it.
What is amortization?
Amortization is the process of dividing the cost of an intangible asset such as a patent, copyright or loan into smaller instalments over a specific period. These instalments include both the principal amount as well as the interest charged by the lender. The goal of amortization is to allow the borrower to repay the debt in a more manageable manner and reduce the risk of default.
In the case of loans, amortization typically involves a fixed monthly payment that consists of both interest and principal. In the early stages of amortization, a large portion of the payment goes towards interest, while the rest goes towards reducing the principal. Over time, the interest portion decreases, and the principal portion increases, until the entire principal is paid off.
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How does it work?
Here's an example of how amortization works:
Let's say a company purchases a patent for $100,000 with a useful life of 10 years. The company decides to amortize the patent using the straight-line method, which means equal amounts are allocated to each year of the asset's life.
Formula:
Annual amortization expense = (Purchase price - Residual value) / Useful life
In this example, let's assume there is no residual value for the patent, meaning it will have no value at the end of its useful life. Using the formula:
Annual amortization expense = ($100,000 - $0) / 10
Therefore, the annual amortization expense for the patent would be $10,000.
Each year, the company would record an expense of $10,000 on its income statement to reflect the cost of the patent being used up over time. As each year passes, the accumulated amortization increases, and the carrying value (net book value) of the patent decreases until it reaches zero at the end of its useful life.
It's important to note that the actual calculation and treatment of amortization may differ depending on accounting standards and specific circumstances.
Why is amortization important for traders?
Traders usually take loans to finance their investments, and loans require periodic payments of principal and interest. Amortization schedules help traders keep track of these payments, particularly for loans with different interest rates.
For example, if a trader takes out a loan for $10,000 at a 5% interest rate and pays it back over five years, they will have to pay $1,932.16 every year, including $463.75 in interest. If the trader takes out another loan for $20,000 at a 7% interest rate and pays it back over ten years, they will have to pay $2,483.48 every year, including $1,383.48 in interest. The schedule helps the trader plan their cash flows and budget accordingly.
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