Amortization loan
It is difficult to imagine life without credit cards, car loans, home loans, etc. Loans were once considered a taboo. Nowadays, people fulfill their desires by borrowing from their future earnings. These future earnings will more likely be in form of monthly or annual receipts. Correspondingly, loan repayments are now being structured to suit such earning patterns. One such type of repayment structuring is amortization of loans. What it means is that loan is repayable in smaller bits through equated installments, part of which is towards the loan and remainder is towards interest. A schedule for payment of these equated installments covers the entire tenure by end of which, the loan is completely repaid. This is the basic idea behind any amortization loan.
Loans may be amortized either in straight-line method or reduced balance method. They may be amortized every month or quarterly or year, or any other equated period within loan tenure. They may also be paid up completely at one go. Or there could be a moratorium during which, some interest is to be paid on the outstanding loan, and thereafter, the repayment schedule of equated installments begins. Yet another way of amortization structure involves accumulation of interest during the moratorium, which is then added back to the loan and amortized during the balance loan tenure. This is termed as negative amortization. The borrower may also opt for ballooning form of amortization. Such type of amortization caters to the needs of those borrowers, who expect to receive substantial amounts from other sources during the tenure of loan. And these borrowers either intend to repay part of the loan with help of these anticipated receipts or borrow a higher amount based on such receivables.
Advantages of amortization loan are that they make desires, like vehicles, homes, vacations, etc., quite affordable. These loans are granted by lending consortiums or bankers, who are unlikely to behave like mafia loan sharks. At the worst, if loan is not repaid, a bankruptcy proceeding is initiated against the borrower. As they are pre-defined fixed charges, it's easy to plan cash flows of future. Moreover, these loans are generally long-term loans, so they carry lesser rate of interest when compared to short-term loans. Interest component from equated installment is allowed as an expense for income-tax purposes. And though it looks like quite a lot of interest is being paid on the loan during the long tenure, the actual payment is much less because these payments are not in present value of money. Amortization loans can also be used to retire expensive debts and consolidation of all the indebtedness when cheaper refinance is available.
Major disadvantages of amortization are that one has to be prompt with these installments, else they get added back to loan and result in compounded effect. Some amortization loans look cheap on the face of it, but are rather expensive. This is especially true in case of amortization loans that are calculated in straight-line method. Another drawback is the interest rate fluctuation risk in amortization loans that allow adjustable interest rate mortgages (ARM). Such ARMs can spring nasty surprises when interest rates start climbing. The borrower could end up paying higher installments, or more number of installments.
International Accounting Standard 38 for intangible assets and the Generally Accepted Accounting Principles (GAAP)'s Statement of Accounting Standards No.142, Goodwill and Other Intangible Assets are the most commonly used standards for treating amortization in accounting books.
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