Amortization is an accounting term that describes the method used for allocating the capital costs of intangible assets over time. It is also often used as a method for creating fixed payments on a loan or bond with a rate of interest so that the payments stay the same for the entire duration of the loan.
Amortization In Capital Costs
Companies use this method to spread the cost of intangible assets over the period of their useful life. For example, a $10,000 patent that is expected to create revenues for a period of 10 years would have an amortized cost of $1,000 each year.
This method matches the costs of intangible assets with the revenues that they generate by spreading the cost over the revenue-generating years of that asset.
Amortization In Loans & Bonds
Amortization in loans and bonds is a method of establishing fixed payments for the entire duration of the loan or bond.
Instead of separate interest and principal payments, often with the entire principal being repaid in one lump sum at the end of the loan period or bond expiration, it lumps the interest and principal payments together for the entire duration of the loan using a complex mathematical formula.
Amortization simplifies the borrowing process by allowing the borrower to budget for fixed payments over the entire length of the loan or bond.
Amortization & Depreciation
While similar in principle to amortization, depreciation is an alternate accounting method that is used to spread the cost of tangible assets over the duration of their useful life.
While intangible assets do not physically deteriorate in value, physical assets do, so the discounting method should account for the actual value lost over each accounting period, which will often vary with time.
Amortization is an important concept for day traders to understand as it is widely used by companies in their financial statements.
While there is no need to understand the complex mathematics that drive amortization formulas, an understanding of the basic principles of amortization allows day traders to evaluate a wide variety of the financial decisions that companies make.