How To Calculate Amortisation (With Definition And Example)
By Indeed Editorial Team
Published 7 September 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Amortisation is a financial process that helps in spreading a loan over multiple payments depending on the loan terms. Understanding how to calculate amortisation can help you make smarter investment decisions about loans and help monitor intangible assets. If you plan to take a mortgage or auto loan, you might want to know everything about amortisation. In this article, we discuss what amortisation is, review the steps to calculate amortisation for loans, learn its benefits and discover how amortisation works with one sample answer.
What Is Amortisation?
Amortisation is an accounting process in which the monetary value of a loan or intangible asset decreases. It primarily means the reduction of a loan over a specific time. Amortisation primarily focuses on paying the same amount every month. Recording these payments over time reduces the loan's value over its terms. By calculating amortisation, individuals and finance professionals can understand how to pay off their loans in a specific period. It can help them identify how much of their payment is the interest amount and how much is the principal amount.
As they repay more principal amount, less interest becomes due on the loan payment. Often, amortisation refers to intangible assets like trademarks, copyrights and patents. They can even use it to distribute the cost of assets throughout its life.
How To Calculate Amortisation
To understand how to calculate amortisation, use the following steps:
1. Collect the information required to calculate loan amortisation
For calculating the amortisation of your loan or intangible asset, it is essential to know the principal amount and interest rate. You also require the loan's term and the payment amount for each period. You require the following information:
Principal amount: The principal amount is the current loan amount. For instance, if you are paying a three-year car loan and have a balance of ₹10,00,000, then ₹10,00,000 is the principal amount.
Interest rate: If you pay an interest of 3% per annum, convert it to a monthly interest rate.
Time period: Convert the term of your loan into months. If your loan period is three years, in months, it becomes 36 months.
2. Create a spreadsheet
Calculating amortisation is ideal in a spreadsheet because it involves a lot of calculation. Start by creating a spreadsheet, pre-loaded with information and column headings, such as principal, interest rate, principal payment and ending principal amount. For the above example, ensure that the number of rows below the column headings is 36 to accommodate each monthly payment.
3. Calculate the interest payment for the first month
To calculate the interest payment, divide the yearly interest by 12 to get your monthly interest payment. In the above example, divide 3 by 12 to get 0.25% per month. Now, use the formula:
Interest = Principal x Interest rate x Time
Principal = ₹10,00,000
Interest rate = 0.25% or 0.0025
Time = 1 month
Interest = 10,00,000 x 0.0025 x 1 = ₹2,500
Your monthly payment is ₹29081.21
4. Calculate the principal portion for month one
Calculate the principal portion for month one by subtracting the interest for the first month from the principal or monthly payment. For the above example:
Monthly payment = ₹29081.21
Interest payment = ₹2,500
Principal payment = Monthly payment – Interest payment = 29081.21 – 2500 = ₹26581.21
5. Calculate the amortisation for the second month
For calculating the amortisation value for subsequent months, subtract the principle amount you repaid in the prior month.
The principal amount for month two = 10,00,000 – 26,581.21 = ₹9,73,418.79
Interest for month two = 9,73,481.79 x 0.0025 x 1 = ₹2433.54
6. Identify the principal repayment for the second month
Like the first-month calculation, you subtract the interest from the first month from the total monthly loan payments. The remaining amount is the principal repayment for the month.
Principal repayment in month two = ₹29081.21 – ₹2433.54 = ₹26,647.67
The principal repayment in the second month (₹26,647.67) is higher than the first month's repayment (₹26,581.21). This is because your principal balance declines each month and you pay less interest on the balance.
7. Understand the amortisation trend
As the principal loan amount gets reduced each month, the interest also decreases. The new principal balance for the third month is:
Principal repayment for third month = ₹9,73,418.79 – ₹26,647.67= ₹9,46,771.12
Interest repayment for third month = ₹9,46,771.12 x 0.0025 = ₹2366.92
Principal repayment in third month = ₹29081.21 – ₹2366.92 = ₹26,714.29
8. Know the impact of the amortisation at the end of the loan term
With time, the interest charged for your loan each month declines. The principal part can increase with time and the remaining parts get smaller. By the end of the term, the principal amount is zero and the interest payments become zero. This shows full repayment of the entire loan amount along with interest.
When Do You Use Amortisation?
Here are some instances where you might use amortisation:
Making financial decisions
When taking a home or car loan, you want to calculate the monthly payments to ensure you make a viable and wise investment decision. Often, making a financial decision based on the payment amount is not advisable. This is because you might pay a low monthly amount but might pay much more in interest. A good loan term is when you can pay your principal amount each month because it decreases your interest payment. Typically, the quicker you pay your loan, the less you pay interest.
Creating an amortisation chart can track your future payments if you want to measure how much you might pay on your loan. It can help you understand what percentage of payments you make as interest or the principal amount. By tracking and monitoring payments, you can know if you are paying the exact monthly amount for your loan.
Recording the value of intangible assets
When you or your company buy an intangible asset, its value decreases. This is because you are consuming the asset, so its value decreases. Typically, on your balance sheet, you record the full value of your intangible assets and the amortisation expense on your income statement.
How Does Amortisation Work?
Individuals and companies use the concept of amortisation with loans, such as auto and home loans. Though the monthly payment for your loan remains the same, many parts of the payment change when you pay the outstanding principal balance. Typically, interest costs are costly at the start of the loan, especially when the loan is for the long term.
During your loan's early years or months, the interest payments are high and you only contribute a small amount toward the principal balance. Loans that get amortised help an individual pay off the loan balance entirely within a set period. For instance, if you have a 20-year home mortgage or 240 monthly payments, in exactly 20 years, that loan gets paid.
Example Of Amortisation Of A Loan
Here is an example for calculating the amortisation of a loan:
Sunil takes an auto loan for ₹1,00,000 and a payment period of four years with an interest rate of 9%. He creates an amortisation schedule to monitor the amortisation of loans.
Interest period = 4 years = 4 x 12 = 48 months
His loan is for ₹1,00,000, which is her principal amount for the first month. His interest payment is 9% per annum. He converts the annual interest rate to the monthly interest rate. He creates an amortisation schedule with 48 rows on his chart.
Monthly interest rate = 9/12 = 0.75% or 0.0075
Monthly interest for first month = 1,00,000 x 0.0075 = ₹750
Monthly payment = ₹2488.50
Principal amount for first month = ₹2488.50 – ₹750 = ₹1738.50
Principal payment for first month = ₹1,00,000 – ₹1738.50 = ₹98,261.50
Monthly interest for the second month = 98,261.50 x 0.0075 = ₹736.96
Principal amount for the second month = ₹2488.50 – ₹736.96 = ₹1751.54
Principal payment for the second month = ₹98,261.50 – ₹1751.54 = ₹96,509.96
Sunil can continue this calculation for all 48 months. He can use this chart to record how payments might affect her amortisation by recording how much of the principal amount he makes and how it might affect the interest rate.
Explore more articles
- Different High Income Skills
- What Is Market Penetration? (Plus How To Calculate It)
- What Is Big Data Hadoop? (Definition And Career Opportunities)
- What Are Shares Outstanding? (Definition And Calculation)
- What Is B2C? (With Types Of Business-To-Consumer Marketing)
- What Is Buying Power? (With Definition And Examples)
- A Guide To Client Relationships (Plus Effective Strategies)
- REST Vs. SOAP Web Services: What Are The Differences?
- What Is Virtualisation? (Definition, Types And Uses)
- What Is A Brand Voice? (With Importance And How To Create)
- What Are Organisation Skills? (Plus How To Improve Them)
- A Guide To Configuration Management Database (CMDB) Tools