Amortization

Amortization (also spelled amortisation) has two related meanings in finance. In lending, it is the gradual repayment of a loan through scheduled instalments that each cover the interest due plus part of the principal, so the balance falls to zero by the end of the term. In accounting, it is the systematic spreading of the cost of an intangible asset, such as software, a licence or a patent, over the period in which it produces benefits.

Both senses share the idea of reducing a large amount step by step over time. Accounting amortization is the intangible-asset counterpart of depreciation, which applies to physical assets. Loan amortization is the standard structure for a mortgage, car loan or personal loan, and contrasts with interest-only or "bullet" loans, in which the whole principal is repaid at the end, as with most bonds. The term also appears in accounting for financial instruments, where "amortized cost" measures loans and bonds by spreading premiums, discounts and fees over their lives.

Think of eating a large cake over a week. Rather than finishing it in one sitting, a slice is taken each day until it is gone. A repayment loan works the same way: each monthly payment removes a slice of the debt, together with a charge for borrowing what remains.

In the early months, most of each payment goes on that borrowing charge, because the remaining debt is large. As the debt shrinks, the charge shrinks too, so more of each payment reduces the balance. By the final payment, almost all of it is paying off the last of the loan.

For a loan with a fixed rate and equal payments, the payment per period is:

• $A$ is the payment each period.
• $P$ is the principal borrowed.
• $r$ is the interest rate per period, written as a decimal (the annual rate divided by 12 for monthly payments).
• $n$ is the total number of payments.

Worked example: a $10,000 loan at 12% a year, repaid monthly over one year, has $r = 0.01$ and $n = 12$. The formula gives a payment of about $888.49. In the first month, interest is $10{,}000 \times 0.01 = 100$ dollars, so $788.49 reduces the principal to $9,211.51. In the second month, interest is about $92.12 and principal repaid about $796.37. Listing every payment this way produces an amortization schedule. The formula rests on the time value of money and compound interest.

Variations include negative amortization, where payments are smaller than the interest due so the balance grows, a feature of some adjustable-rate mortgages before the 2008 financial crisis; and balloon loans, which amortize partly and leave a large final payment. In Islamic finance, diminishing partnership structures such as musharakah mutanaqisah achieve a similar step-by-step transfer of ownership without interest.

Under IAS 38, an intangible asset with a finite useful life is amortized over that life, usually straight-line unless another pattern better reflects how its benefits are used. The calculation mirrors straight-line depreciation: a five-year software licence costing $500,000 with no residual value is amortized at $100,000 a year, and after two years its book value is $300,000.

Intangibles with an indefinite life, such as some trademarks, are not amortized but tested annually for impairment. Goodwill is not amortized under IFRS or by US public companies, which instead test it for impairment; since 2014 US private companies may elect to amortize goodwill over up to ten years. Amortization of acquired intangibles can be large after takeovers, which is why analysts often look at earnings before interest, taxes, depreciation and amortization, or EBITDA, and at adjusted earnings that exclude it.

Tax treatment varies by country. In the United States, most acquired intangibles, including goodwill, are amortized for tax over 15 years under Section 197 of the Internal Revenue Code, even though goodwill is not amortized in public-company accounts.

Under IFRS 9, a bond or loan held to collect its contractual cash flows is usually measured at amortized cost: the original amount adjusted by spreading any premium, discount or fees over its life using the effective interest rate. Banks hold large portfolios on this basis, which keeps short-term price swings out of reported results; the risk is that unrealized losses can build up unseen, as happened at several US banks in 2023 when rising interest rates cut the market value of their bonds.

The idea of spreading a one-off cost also appears outside accounting standards. Governments amortize national debt through regular redemptions, and businesses speak of amortizing set-up or onboarding costs over a customer's lifetime, as in KYC amortization. Related decisions about which costs to capitalize sit within capital allocation.

• IFRS Foundation: IAS 38 Intangible Assets
• IFRS Foundation: IFRS 9 Financial Instruments