What is amortization?

Amortization is the process of spreading out the cost of a loan or an intangible asset over a specific period of time. This is typically done by making regular payments that include both principal and interest, with the goal of paying off the loan or asset in full by the end of the term. Amortization is commonly used in the context of mortgages, where borrowers make monthly payments that gradually reduce the outstanding balance of the loan.

Amortization refers to the systematic allocation or distribution of the cost or value of an asset or liability over a specific period. It is typically used in accounting and finance to spread out the impact of a one-time expense or income over multiple accounting periods, matching expenses to the periods that benefit from them.

In accounting, amortization is most commonly used to recognize the expense associated with intangible assets (e.g., patents, trademarks, copyrights) and deferred expenses (e.g., prepaid insurance, rent). These assets and expenses have no physical form but provide benefits over a period longer than one year. By amortizing the cost or value of these items, companies can recognize the expense gradually as the asset is used or the benefit is realized.

Mortgage loans also involve amortization. In this context, amortization refers to the gradual reduction of the loan balance through regular payments over the loan term. Each payment consists of both interest (paid to the lender for borrowing the money) and principal (the amount used to reduce the outstanding loan balance). As the loan is amortized, the portion of each payment allocated to principal increases, while the interest portion decreases. This arrangement allows the borrower to pay off the loan in full by the end of its term.

Additionally, bond issuance may involve amortization. In this case, amortization refers to the process of gradually reducing the premium or discount associated with a bond. When a bond is issued at a price above its face value (i.e., at a premium), the premium is amortized over the bond's life by allocating a portion of it to interest expense in each accounting period. Conversely, if a bond is issued at a price below its face value (i.e., at a discount), the discount is amortized by adding a portion of it to interest income in each accounting period. This amortization process ensures that the bond's carrying value (the price at which it is recorded on the issuing company's financial statements) gradually approaches its face value as the bond matures.