You might not know it, but you’ve probably repaid loans with amortization schedules. Because of this, home, student, car, and business loans always have a predictable monthly and interest payment.
But there’s much more to amortization: You can also spread your related capital expenses and intangible assets over time. Let’s dive into what amortization is, why you might benefit from an amortizing loan, and how amortization might impact your business’s books.
What is amortization?
Amortization traces back to the Latin word amortisen, which means “to kill.” Think of it as a process that helps you kill off your debt, breaking it down into digestible monthly payments so you can slay a chunk of it each month.
When your debt is amortized, you know when it will end and what it takes to get to that point. That’s because a tidy mathematical process is hard at work behind the scenes. This is called an amortization schedule.
Amortization ensures your loan amount and interest charges are neatly spread out throughout your loan to reduce the risk for the lender. In turn, it also helps keep your monthly interest rate reasonable, enabling you to borrow a large amount over a longer term.
How an amortized loan benefits the borrower
As a business owner, you benefit from predictability: You know you have a fixed interest rate so that you can plan and budget accordingly. But even more importantly, when your loan repayments are calculated with amortization, they tend to be more affordable.
That means, even as a small business owner with modest sales, you can take out a $50,000 loan to help you buy the high-value equipment you need to run your business while still managing your loan payments.
A real-life example
A few months ago, Ellie started a food cart business called Ellie’s Empanadas. Ellie needs $30,000 to renovate the interior of her food truck and buy a new commercial-grade oven, fridge, generator, and cooking supplies.
She has a few loan options: A credit card, a simple interest loan, or an amortized loan.
If Ellie uses a credit card to renovate her food truck, she might not have enough credit to purchase the quality equipment she needs to make good-quality empanadas. Since her business just started, Ellie can’t pay back all the money right away – meaning she could end up owing a fortune in interest, especially since the interest rate for business credit cards is over 20%.
A simple interest loan is also a consideration, but Ellie found that the payment period was too short, putting her total monthly payment out of her budget.
So, loan amortization it is: With a five-year loan and 8% interest, her monthly payment will be about $608. Ellie looks at her financial statements and decides this monthly payment is manageable.
Now Ellie can take out the loan, repay it without running into cash flow problems, and focus on making empanadas for her customers – and working on some new recipes for her business.
How amortization benefits the lender
For lenders, the aim is to get their money back with interest. With amortization, a loan is sectioned off into neatly packaged, digestible monthly payments that the borrower can afford over a long period.
So amortization also helps lenders because of predictability: The lender knows with an agreed-upon loan term, the borrower should be able to repay the debt.
Additionally, because the bulk of the interest is charged toward the first half of the loan, lenders can receive a decent chunk of their interest revenue immediately instead of waiting several years.
What is an amortization schedule?
An amortization schedule breaks down all your monthly loan payments. It lays out all the details in a table format — beginning loan balance, principal repayment, and how much you pay in interest each month.
- The beginning loan balance is your starting balance
- The principal is the amount of your payment that goes toward your loan balance
- The interest is the amount of your payment that goes toward interest charges
- The balance is how much is left after each payment
Here’s an amortization schedule for Ellie’s Empanadas’ $30,000 five-year loan with an 8% interest rate:
If Ellie starts paying her loan in January 2023, this is what the first ten payments will look like. Notice how, at first, nearly one-third of each $608 monthly loan payment goes toward interest.
Now, look at what happens at the end of the loan:
The principal and interest look completely different because Ellie paid most of the $6,498 in total interest for the loan — about 61% of the interest — in the first two years.
As you can see, most of every $608 payment goes toward reducing the principal amount. And, by the final loan payment, almost the entire amount goes toward the principal.
What if I want to pay off my loan early?
You might be inspired to make early repayments when you look at the interest charges on your loan amortization schedule. After all, the more often you pay extra on the principal, the lower the interest charges on each subsequent payment.
In other words: Paying more than your fixed monthly amount means you’ll pay lower toward the end of the loan.
For example, when Ellie’s Empanadas had record-breaking sales in June of 2023 due to a big music festival in town, Ellie put some of the unexpected revenue toward the debt. By doing so, Ellie’s overall interest expense decreased.
Quick tip: Check your loan terms to determine if there’s a penalty for paying early.
How to calculate an amortization schedule
While you could go to your lender and see what interest ranges you’re offered, you should always calculate at home first to know your cap. If you don’t, you might accept unrealistic terms.
There are three different ways to calculate an amortization schedule. One option requires a few formulas, while the other two are easy to plug in and understand.
Let’s get started.
Option #1: Formula for calculating the monthly principal due
First, you’ll need to manually determine the principal payment month by month by using a distinct formula for calculating an amortization schedule.
Start by taking the total loan amount and multiplying it by the interest rate. Then, to find the amount of interest per month, divide by 12 (for the number of months in a year).
(Starting Loan Balance x Interest Rate) / 12 = Interest
So, for Ellie’s loan, we would have the following:
$30,000 x .08 = $2,400
$2,400/12 = $200
Since you already know your monthly payment when you get the loan, you can subtract the interest to determine the principal amount.
Total Monthly Payment – Interest = Principal
$608 – $200 = $408
That gives you all the inputs for the first line of your amortization table.
Next, you would have to subtract the principal amount ($408) from the existing balance ($30,000) to find your starting loan balance for the second line ($29,592). Then you repeat the same calculations to find the interest and principal repayment for each month of your loan term.
This method is time-consuming, especially if you take out a five-year loan like Ellie’s Empanadas. But luckily, there’s an easier way: The amortization schedule
Option #2: Amortization schedule calculator
You can plug your loan balance, interest rate, and term into a business loan calculator and generate an amortization schedule.
While quick and easy, you’ll need to keep a separate record of your repayment schedule. That’s where the third option comes in: Using software.
Option #3: Spreadsheet software
Businesses can use Excel or Google Sheets to calculate and track monthly payments. When you create the schedule using software, you have total flexibility over the inputs.
For example, if you want to see what happens when you make an early repayment of $1,000 at month 10, you can see how this would impact your loan using your spreadsheet.
The only problem is you might not be an Excel wizard. Fortunately, tracking your expenses and using an amortization table to help you budget is a breeze with automation software.
With automated expense-tracking software, track your business expenses, monthly mortgage payment, income, and much more. Automated programs like this can do the heavy lifting for you so that you don’t have to worry about making calculations.
How to calculate amortization for an intangible asset
If your business invests in intangible assets, you can amortize your capital expenses over time (usually the life of an asset). By using amortization, you spread the capital expenses over several years instead of claiming them all in one tax year.
To understand how this accounting technique works, let’s look at what Ellie does when she invests in a patent for her unique hot sauce, which she’s ready to bottle and sell alongside her now-famous empanadas.
Ellie’s bookkeeper totals the cost of the patent at $20,000. The patent lasts for 20 years, so Ellie’s Empanadas annually writes off $1,000 as an amortization expense.
The bookkeeper records this expense as a reduction on the balance sheet and an expense on the income statement. Doing this ties the asset’s cost to the revenue it generates (which aligns with the matching principle of generally accepted accounting principles, or GAAP).
In short, amortization can make your life easier as a business owner. Once you understand how much you have to pay each month, you can use it to optimize your business finances, plan ahead, and help your company thrive.
Plan accordingly with spend management software
Whether you’re amortizing a business loan or an intangible asset, understanding how the process works is crucial for any business owner. However, knowing the ins and outs of amortization doesn’t make managing your finances any easier.
That’s where BILL comes in.
With our spend management software, you can create a budget in advance based on your expected income and expenses and avoid financial surprises down the road. Learn more about BILL today and see how our automated software can help streamline your spending and loan payments.