Amortization Definition & Video Example


What is amortization?

An amortization is the repayment of a debt, and can consist of parts or the entire amount. The repayment on a loan can be done in different ways through an installment plan. The three most common installment plans are straight amortization, annuity or amortization-free loan.

Calculation example of amortization requirements

Example 1:
You want to buy an apartment for $200,000 and borrow $170,000. You earn $30,000 per year before tax. Your amortization will be 2 percent + 1 percent:

  • You borrow 85 percent of the value of the home (170,000 / 200,000) = 2 percent repayment.
  • The loan amount is higher than 4.5 times your annual income = 1 percent repayment.
  • This means that your total amortization will be 3 percent of $170,000.

Example 2:
You and your partner already have a mortgage on your villa of $200,000. You have a joint annual income of $60,000 before tax.

You buy a holiday home for $180,000 and borrow $110,000. Your amortization will be 1 percent + 1 percent:

  • You borrow 61 percent of the value of the home (110,000 / 180,000) = 1 percent amortization.
  • Total borrowing (200,000 + 110,000) is higher than 4.5 times the annual income = 1 percent amortization.
  • Which means that your total repayment will be 2 percent of $110,000 (the loan amount at the holiday home). The previous mortgage on the villa is not affected.

What is straight amortization?

In the case of a straight amortization, the amortization part of what you pay each month is the same amount (amortization + interest).

This means that the amount you pay each time for your loan decreases over time, as your debt decreases and then also the interest rate.

What is an annuity?

This means that you as a borrower pay a fixed amount, which is a lump sum for loans and interest. The amount does not change over time when your debt decreases, but is the same throughout the repayment period.

Since the amount is constant, however, both the loan part and the interest part change over time.

The debt decreases for each payment, but unlike with straight amortization, this does not happen linearly, but the debt decreases more slowly at the beginning and faster at the end of the repayment period.

How does an amortization-free loan work?

You do not pay an amortization-free loan on an ongoing basis, but instead the entire amount at the end of the term.

In 2016, an amortization requirement was introduced for all new mortgages, which means that you must repay at least 1% of the loan amount.

What are the benefits of amortization?

The first reason can be considered obvious, a borrowed amount must always be repaid.

But there are more benefits. Paying off the borrowed total amount means that you reduce your interest rate as the loan becomes smaller and smaller.

It also opens up opportunities for additional loans should this be needed.

If you have used your borrowed money to invest in, for example, a condominium that can increase in value, you can make a financial profit from the sale.

How do I amortize

As I have mentioned, there are annuity loans and straight amortization. An annuity loan means that you pay back a fixed amount to the bank on a monthly basis.

As the loan decreases, you pay less interest but the installment becomes higher. However, the total amount each month remains the same.

In the case of straight amortization, the amortization amount is the same every month.

The interest rate, on the other hand, is higher in the beginning but decreases as the loan amount decreases. This means that the monthly total is higher at the beginning but decreases at the end.

Amortize smart

If you as a consumer have several loans, it is important to repay smart. It is not the size of the loan that will determine whether you should repay more or faster.

It is rather the cost of the loan that will determine this. By comparing which of your loans are the most expensive, you can also see which ones you should repay as soon as possible.

By amortizing smart, you can save many thousands every year. In other words, it pays to review your loans and repayments.

Straight amortization

In the case of straight repayment, you repay the loan in an equal amount at each payment occasion. In addition to amortization, you pay interest

1. The total monthly cost is greatest in the beginning

This is because the interest cost is highest in the beginning when the debt is greatest. Straight amortization is almost always used for home loans.

2. The debt is divided into equal parts

In the case of straight amortization, the debt is divided by the number of amortization opportunities agreed.

For example, if you borrow $100,000 to be repaid in five years and you repay each month, it will be five years times twelve months, ie 60 repayments.

If you divide $100,000 on 60 amortization occasions, it will be approximately $1,665 at each amortization occasion.

If you instead choose to amortize every quarter, it will be five years times four quarters, ie 20 amortization opportunities.

$100,000 divided into 20 amortization occasions will then be $5,000 at each amortization occasion.

3. The debt decreases with each repayment

Because the amount you repay is the same throughout the term of the loan, the debt decreases with each repayment.

Therefore, the interest rate and thus the cost of the loan will be lower each time you repay, provided that the interest rate on the loan is not raised.

4. The debt decreases faster with straight amortization

The debt decreases faster with a straight repayment model and your cost of interest during the term of the loan will be lower overall.

Annuity

If you have an annuity, an amount is determined, the annuity, which is sufficient for both the interest on the debt and the amortization.

1. The same payment amount every month

If the interest rate does not change, the total monthly cost will be the same at each payment occasion. Since the annuity is the same at each occasion, it consists at the beginning of the term of the loan for the most part of interest and to a lesser extent of amortization.

Towards the end of the term when the debt has become smaller, the interest rate constitutes a smaller part of the annuity and the amortization a larger part.

The repayment must be so large that the loan will be repaid in full when the term of the loan ends.

To be able to calculate the annuity, you need to know the loan amount, the interest rate and the number of payment opportunities.

2. If the interest rate changes

A condition for the annuity not to change is that the interest rate does not change during the term of the loan. However, loans with an annuity often have variable interest rates.

If the interest rate changes during the term of the loan, the lender can handle this in two different ways, either through a retained annuity or through a changed annuity.

3. Retained annuity (false annuity)

Retained annuity, also called false annuity, means that the annuity does not change when the interest rate changes.

If the interest rate is raised, the annuity will to an even greater extent consist of interest expense and to a lesser extent of amortization.

This means that the debt will not be paid in full at the end of the term and the term of the loan will be extended.

If the interest rate is reduced, the loan will be repaid before the end of the term, as a smaller part than expected has been used to pay interest.

4. The term of the loan is extended

The advantage of maintaining an annuity is that you know in advance exactly how much you will pay for the loan each month, regardless of what happens to the interest rate level.

The downside is that the term of the loan may not be what you thought it would be.

You may therefore have to pay off the loan for a longer period than you had intended. In extreme cases, a sharp rise in interest rates can even mean that the annuity is not even enough to pay the interest on the debt.

The debt will then grow! The lender should then inform you of this and propose an increase in the annuity that covers the interest cost.

5. Amended annuity (true annuity)

A loan can also have a changed annuity, also called a true annuity.

In contrast to the retained annuity, this means that the lender recalculates the annuity each time the interest rate changes.

The advantage of this is that the term that you and the lender initially agreed on is always kept.

The downside is that it can be difficult for you to know in advance how much you will have to pay at each payment occasion.

Serial amortization

Another, and quite unusual, way to repay a loan is with serial amortization.

1. The size of the repayment changes during the term of the loan

On so-called serial loans, the size of the repayment gradually increases during the term of the loan.

It is often a step-by-step model, ie the amortization is, for example, one percent of the debt for the first five years, years six to ten is the two percent of the debt, and so on.

Conclusion

How much do you have to amortize?

Your amortization is calculated based on how much you borrow in relation to what the home is worth and your income.

  • Mortgages over 70 percent of the value of the home must be repaid with at least 2 percent of the total loan amount per year.
  • Mortgages over 50 percent up to 70 percent of the value of the home must be repaid with at least 1 percent of the total loan amount per year.
  • If you borrow more than 4.5 times your annual income before tax, you must also repay 1 percent of the total loan amount per year. If you are several who apply for a mortgage, it is your total annual income before tax that applies.
  • If your mortgage is 50 percent or less of the value of the home and you borrow less than 4.5 times your annual income before tax, there is no requirement for amortization.

Sources

https://www.sciencedirect.com/science/article/abs/pii/0165410195004106

https://www.jstor.org/stable/239096

https://www.tandfonline.com/doi/abs/10.2469/faj.v57.n5.2478

https://www.jstor.org/stable/2490921

https://www.journals.uchicago.edu/doi/abs/10.1086/259813

https://ieeexplore.ieee.org/abstract/document/1004374

https://meridian.allenpress.com/accounting-horizons/article-abstract/15/3/243/52314/How-Informative-Are-Earnings-Numbers-That-Exclude

https://urresearch.rochester.edu/institutionalPublicationPublicView.action?institutionalItemId=4899

https://www.researchgate.net/profile/Revaz-Lordkipanidze/publication/333825716_Economic_Views_of_two_World-famous_Leaders_from_Small_Georgia_-Shevardnadze_and_Stalin_and_How_to_Avoid_Moral_Amortization_of_Global_Economic_Structures_-Tbilisi_General_Coordinator_of_International/links/5d07b4a8299bf1f539cb0aa5/Economic-Views-of-two-World-famous-Leaders-from-Small-Georgia-Shevardnadze-and-Stalin-and-How-to-Avoid-Moral-Amortization-of-Global-Economic-Structures-Tbilisi-General-Coordinator-of-International.pdf

https://www.sciencedirect.com/science/article/abs/pii/S0010027718301094

Kevin

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