In plain English
For intangible assets, amortization is like depreciation: a cost spread over its useful life. For loans, an amortization schedule shows each payment split into interest and principal.
On a loan, early payments are mostly interest and later payments mostly principal.
Why it matters
On a loan, amortization tells you how much of each payment is actually reducing what you owe. If you record the full monthly payment as an expense, your profit is understated and your loan balance never seems to shrink in the books, which confuses both you and your tax preparer.
For intangible assets such as purchased software licenses, a bought customer list or certain startup costs, amortization spreads the cost over the years you benefit from it. That keeps one year from absorbing a cost that helps several years.
Worked example
A $60,000 loan has a $1,850 payment. In month one, $400 is interest and $1,450 is principal, so the balance falls to $58,550.
How to handle it
- Ask the lender for an amortization schedule, or build one in a spreadsheet from the rate, term and loan amount.
- Record each loan payment by splitting it between interest expense and the loan liability using the schedule.
- Compare the loan balance in your books to the lender's statement at least once a quarter.
- For an intangible asset, record the purchase as an asset and post a regular entry moving part of its cost to amortization expense.
- Keep the schedule and supporting documents with your year end records for your preparer.
Common mistakes
- Recording the entire loan payment as an expense, which overstates expenses and leaves the loan balance too high on the balance sheet.
- Splitting payments with a rough guess instead of the actual schedule, so the books drift away from the lender's balance.
- Expensing a large intangible purchase all at once when it should be spread over time, which distorts profit for that year.
- Forgetting escrow, insurance or fees that are bundled into a loan payment, which then end up in the wrong account.
Not the same as: Depreciation
Depreciation spreads the cost of physical assets like equipment. Amortization spreads the cost of intangible assets or tracks how a loan is paid down. See Depreciation.
Go deeper
- Business Loan Records: Interest, Principal and Covenants: How to record business loans correctly, split payments between interest and principal, and keep the paperwork lenders and preparers ask for.
- How to Record a Business Loan in Your Books: Step-by-step bookkeeping for business loans: recording proceeds, splitting payments into principal and interest, and reconciling to lender statements.
Try it
Related terms
- Asset: Something the business owns or is owed that has value, such as cash, receivables, inventory or equipment.
- Bad debt: A receivable you have decided you will not collect, written off as an expense.
- Aging report: A report that lists unpaid invoices or bills grouped by how long they have been outstanding.
Common questions
What is amortization?
Spreading the cost of an intangible asset, or the repayment of a loan, over time.
Can you give an example of amortization?
A $60,000 loan has a $1,850 payment. In month one, $400 is interest and $1,450 is principal, so the balance falls to $58,550.
Is loan principal deductible?
Principal repayment is not an expense on the profit and loss because it reduces a debt. Interest is the cost of borrowing. For what is deductible on your return, check with your accountant or the IRS.
Where do I find the interest portion of each payment?
The lender's monthly statement or annual interest summary usually shows it. You can also build an amortization schedule in a spreadsheet using the loan terms.
General information, not tax, legal or accounting advice. Confirm rules with the IRS, the NJ Division of Taxation or a licensed professional.