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The amortization method is a scheduled payment plan — usually a monthly installment — created so that a loan is paid off over a specified loan period. The monthly payments are kept at a fixed amount until the loan is paid off. Car loans and home mortgages typically use the amortization method.
Unlike other repayment methods, the amortization method puts some of the monthly payment towards the interest cost and the rest goes towards paying off the principal amount, or the amount borrowed. Interest is calculated on the current amount owed and will become progressively smaller as the balance of the loan diminishes. Using this method, the beginning payments go mostly towards paying off the interest. Very little of the payment will go toward the principal balance for the first several years of the loan.
There are four categories of amortization methods commonly used by lenders. Full amortization is the most popular type of loan. At the end of the loan term, the outstanding balance of the loan will be reduced to zero. Partial amortization, on the other hand, only slightly reduces the outstanding principal on the loan with each monthly payment. By paying only a partial amount, there will be an outstanding balance at the end of the loan period.
A less popular amortization method is the “interest only” method. Just as the name implies, an individual makes monthly payments which will go only towards the interest. At the end of the loan period, the principal balance is the same as at the beginning. The negative amortization method requires the lowest monthly installments. Because the payments are so low, interest is added to the loan every month and the loan amount actually increases by the end of the loan period.
As an example, let’s look at a fifteen-year mortgage in the amount of $100,000. Using the full amortization method, the loan would be completely paid off at the end of fifteen years. With the partial amortization method, an individual would owe less than $100,000 at the end of the loan term. Under the interest only method, a person would still owe the full $100,000 at the end of fifteen years. Using the negative amortization method, an individual will end up owing more than the original $100,000 by the end of the loan period.
The amortization method is also used in regards to retirement accounts. In this case, the amortization method is an IRS-approved method of distribution calculation which allows penalty-free early withdrawals from personal retirement accounts. However, once the annual distribution amount is fixed, it is never adjusted according to any changes in income level or life expectancy.
How does a company choose which type of amortization method to use for a fixed asset?
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