A loan is a form of debt to finance various needs and operations. Companies often obtain these from financial institutions. In exchange, the lender receives interest income. Accounting standards do not allow companies to account for loans in the same accounting period. Since this finance spreads over several periods, the accounting may require amortizing its cost.
What is Loan Cost Amortization?
Loan cost amortization (or amortization simply) refers to spreading the cost of a loan over its life. This concept applies to specific loans only and not to every form of debt. Usually, it occurs when companies pay the same monthly amount to the lender. This amount covers both principal and interest payments. Therefore, it creates an expense while also decreasing the loan liability.
Amortization also applies to intangible assets, where it spreads their costs over the useful life. For loans, it is similar, allowing companies to decrease the book value of certain debts. Companies use an amortization schedule to reduce the current balance on their loans based on loan cost amortization. This treatment is mandatory under the matching principle in accounting.
What is the Loan Amortization Formula?
Companies use an amortization schedule to separate interest expenses and principal amounts from a monthly payment. This schedule helps measure these amounts over the loan’s life. However, companies can also use the loan amortization formula to calculate monthly payments. Consequently, they can gauge the interest amount.
The loan amortization formula is as below.
A = rP / (n x [1 – (1 + r/n)-nt])
The elements of the above formula for loan amortization are as below.
A = Monthly payments
r = Rate of interest
P = Principal amount
n = Number of monthly payments in a year
Companies can also calculate the interest on the loan using the following formula.
I = (n x A x t) – P
In the above formula, ‘I’ represents the interest.
Practically, companies can use accounting software to calculate these amounts. Similarly, the lender may provide an amortization schedule that shows the interest expense and principal amounts in each monthly payment.
Loan Amortization Formula Example
A company, Red Co., acquires a loan of $100,000 with a 5% interest rate. The company must repay the entire amount to the lender over 10 years with a monthly payment. Based on the above information, the monthly payment amount will be as below.
A = rP / (n x [1 – (1 + r/n)^-nt])
A = 5% x $100,000 / (12 x [1 – (1 + 5%/12) ^-(12 x 10)])
A = $1,060.655
Red Co. can also calculate the interest on the loan as follows.
I = (n x A x t) – P
I = (12 x $1,060.655 x 10) – $100,000
I = $27,278.62
What is the Loan Amortization journal entry?
The loan amortization journal entry is straightforward. It requires recording the monthly payment by separating it into the interest expense and principal payment portions. Usually, it is the same as the journal entry for loan payments with interest, as follows.
| Dr | Interest expense |
| Dr | Loan (Principal amount) |
| Cr | Cash or bank |
The first debit entry above increases the interest expense in the income statement. The second decreases the liability on the loan account in the balance sheet. Lastly, the credit entry impacts the relevant source account used for the monthly payment.
Conclusion
Loan amortization refers to spreading the cost of a loan over several periods. It also represents a decrease in a loan’s book value over its life. Usually, companies use a loan amortization schedule to calculate the principal and interest amounts for each payment. Similarly, they can use the formula to calculate loan amortization. Once these figures are available, companies can put them in the journal entries for loan amortization.
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