Amortisation of Debt Explained for Dummies

What is amortisation?

Commonly, amortisation, also spelled amortization, refers to the process of paying off debt through pre-agreed instalments that comprise both the principal and interest on the debt account.

Put differently, amortisation is the process of spreading out a loan over a certain period, utilising several instalments (regular payments).

Amortisation is also applicable to another situation in which it refers to the accounting practice of spreading an intangible asset’s capital expenses over the asset’s useful life. (Refer to the article, ‘Amortisation of Assets Explained for Dummies’, for more information on this type of amortisation.)

Amortisation of debt

The ins-and-outs of a loan amortisation schedule

A loan amortisation schedule provides a borrower with basic information about the loan. The information included in an amortisation schedule will be explained in the light of the schedule below which is based on a loan of R100 000 at an interest rate of 7% per annum repayable over 12 months.

Calculations

The formula to calculate the payment amount is as follows:

Where:

A = Payment amount per period

P = Principal amount (the initial loan amount)

r = Interest rate per period

n = total number of periods (or payments)

Thus, in the example above, P = R100 000, r = 0.583% per period (month) (7% per year/12 months), n = 12 months or 12 payments (instalments), and A = R8 652.49.

An amortisation payment calculator (available on numerous websites) can also be used to determine the payment amount per period, while Microsoft Excel has various built-in functions for amortisation formulas available. The Excel PMT function corresponds to the formula above.

Knowing the regular payments enables a borrower to decide whether he or she can afford the instalments, usually monthly.

If necessary, it is relatively easy and useful to be able to create your own amortisation schedule if you know what the monthly payment on a loan is.

Let us take the information in the schedule above to explain the calculations of the monthly principal and interest amounts.

Explanation:

• Take the starting balance in month 1 and multiply it by the interest rate on the loan: R100 000 x 0.07 = R7 000.
• Divide the R7 000 by 12 to calculate your monthly interest: R7 000/12 = R583.33.
• Subtract the interest from the total monthly payment to determine the principal repayment (the amount that reduces the principal of R100 000): R8 652.49 – R583.33 = R8 069.16.
• For month 2, take the starting balance of R91 930.84 and multiply it by the interest rate: R91 930.84 x 0.07 = R6 435.16.
• Divide the R6 435.16 by 12 to determine the interest payable for month 2: R6 435.16/12 = R536.26.
• Subtract the interest from the monthly instalment to get the principal repayment: R8 652.49 – R536.26 = R8 116.23.
• Repeat the process for each of the remaining 10 months.

The total loan amount is R103 829.88: R100 000 (principal) + R3 829.88 (interest).

If there is a change in the interest rate, the interest and instalments will be adjusted accordingly.

Basic information

Typically, amortisation schedules include the following basic information:

• The principal (the original sum of the loan).
• The start and end balance for each period (month, quarter, etc.).
• Scheduled payments, also referred to as instalments: The required regular payments (monthly, quarterly) are indicated individually by period for the duration of the loan.
• Principal repayment: After the application of the interest amount, the remainder of the instalment is used to pay off the loan.
• Interest: The portion of each regular payment that covers interest expenses.

In addition, a summary of the loan repayment is provided, usually at the bottom of the amortisation schedule. The summary will include, inter alia, the totals of the interest and principal repayments already paid by the borrower.

The interest charges and principal repayments differ from period (month) to period (month). At the beginning of the loan, interest costs are at their highest but are declining each period. Vice versa the principal repayments.

Types of amortising loans

Instalment loans are mostly amortising loans. For example:

• Vehicle loans (also known as auto loans or car loans)

These loans are available for periods of five years or longer. The longer the period, the higher the interest costs. Depending on the borrower’s credit profile, interest charges can be significantly expensive.

• Mortgages (also referred to as home loans)

A mortgage is a type of loan (debt instrument) that is secured by the collateral of a specified property (for example a house). Typically, mortgages are 20 year or longer loans with much lower interest rates than other instalment loans.

• Personal loans

Normally, personal loans are provided by banks. Terms and interest charges differ from borrower to borrower, depending on his or her credit record and credit profile.

The following types of loans do not get amortised: Credit cards and balloon loans.

Advantages of amortised loans

• The information available in an amortisation schedule enables a borrower to evaluate different loan options, comparing lenders and choosing a loan term that is acceptable.
• Awareness of the instalments helps a person to decide about the affordability of the loan.
• Psychologically, amortisation is a feel-good option, as the burden of interest costs and the outstanding debt is gradually reduced.
• Debt can be paid off early, saving a considerable amount of interest charges.