Straight-line Vs. Mortgage Style Amortization
Amortization is a handy concept when dealing with depleting assets or debts. With certain kinds of debt, such as home mortgages, amortization simply refers to the debt repayment schedule. In the case of bond discounts, bond premiums or intangible assets, such as intellectual property, amortization chips away at value over time much like depreciation does. Different amortization methods are applicable under different situations.
Straight-line amortization involves evenly depleting an asset or debt over a predetermined period. Two common situations in which straight-line amortization is applied are intangible assets such as patents and bond premiums and discounts. Under intellectual property laws, patents expire within a certain number of years. Accountants typically book patents as intangible assets and reduce them by equal amounts every year until they expire. In the bond market, some issuers sell debt at a discount and must repay investors full value. In this case, the discount represents a liability that is expensed annually through straight-line amortization.
Imagine that a company issues a five-year, $100 million bond with a 10 percent coupon. However, because prevailing interest rates are 11 percent, the bond is only appealing to investors if sold at a discount. If the bond sells for 99 cents on the dollar, the company must record a discount on bonds payable liability equal to $1 million. This liability is then amortized evenly by $200,000 annually over the life of the bond ($1 million divided by five years).
When a homeowner takes out a mortgage, she comes face to face with mortgage-style amortization. While mortgage payments remain fixed, the split between interest and principal payments changes dramatically over the life of the loan. In earlier years, the borrower's mortgage payments consist mostly of interest. In later years, the situation reverses, with the bulk of the payments going toward paying down the debt. The reason for this arrangement is that lenders earn profit from interest and therefore collect it as quickly as possible.
Suppose that a homeowner takes out a $200,000, 30-year mortgage carrying a 6 percent interest rate. If he doesn't prepay the loan, the homebuyer will be responsible for making 360 monthly payments of $1,199.10. Under mortgage-style amortization, the first monthly payment would be nearly all interest: $1,000 of interest and $199.10 of principal repayment. The middle payment -- the 222nd monthly payment in the 18th year -- would be evenly split between interest and principal. And the last payment would break down into $5.97 of interest and $1,193.14 of principal repayment.
Giulio Rocca's background is in investment banking and management consulting, including advising Fortune 500 companies on mergers and acquisitions and corporate strategy. He also founded GradSchoolHeaven.com, an online resource for graduate school applicants. He holds a Bachelor of Science in economics from the University of Pennsylvania, a Master of Arts in English from the University of Hawaii at Manoa, and a Master of Business Administration from Harvard University.