What is Straight Line Amortization?
Definition: Straight line amortization is a concept in accounting which deals with the allocation of interest rates, especially on intangible assets at a consistent rate during the life of that asset.
Straight line amortization is particularly used on bonds to allocate interest, and it also refers to the process in which interest expenses tied to bonds are recorded over a specific duration of time, usually the duration in which the bond will be active before it reaches its expiry. Straight line amortization is thus used to amortize a loan, bond, or any other intangible asset by allocating equal amounts of interest for every accounting period, and this is done for the entire duration of the debt.
How does straight line amortization work?
The use case for straight line amortization can be categorized into three parts:
- Determining the interest to be paid for the intangible asset such as the interest that will be paid out where investors put their money in a bond.
- It is used to charge off the intangible asset’s cost.
- Straight line amortization is also used to calculate the monthly installments, for example, the amount that a borrower should pay every month, including interest.
Straight line amortization is considered the easiest method of amortizing a bond or a loan because it focuses on allocating a fixed interest amount. It is usually calculated using a simple formula where the total interest amount is divided by the number of accounting periods that will consist of the life of the debt. This is the expense that is recorded on the income statement each year.
The straight line amortization concept is commonly used by banks to create mortgage and loan amortization schedules. This approach is relatively simple and is slightly different from the approach used in bonds amortization. This is because bonds can be issued at a premium or a discount and even at the market rate. These variations mean that the amortization schedules used for bonds are more complicated.
Straight Line Amortization Formula Calculation
The straight line amortization equation to calculate straight line amortization is quite simple. You subtract the expected salvage value of the intangible asset from its book value, and then you divide that the resulting amount by the number of periods that the asset will be active.
The straight line amortization formula is calculated below:
( Intangible Asset Book value – Expected salvage value) ÷ number of periods.
Straight Line Amortization Example
A company purchases intellectual property for $20,000, and it intends to sell those rights to another firm for $4,000 after five years. Using the straight line amortization formula, the math would look like this:
($20,000-$4,000)/5=$3,200.
In the above example, the amortization per year would be $3,200.
Straight line amortization means the same thing as straight line depreciation. However, the latter is used when dealing with tangible assets, while the former is used for intangible assets. Straight line amortization is also applied when calculating loan repayments through a series or regular repayments. These payments also take into account the principal amount borrowed, as well as the interest rate that the borrower is expected to pay.
When calculating straight line amortization for loans, the lender aims to make sure that the interest is paid first early into the repayment duration. Then the rest of the repayments cater to the principal repayments. In this case, the interest repayments reduce over time as the principal repayments reduce. This allows the borrower to allocate more of the repayments to the principal when the borrower decides to increase the proportions of every repayment.
Summary
Straight line amortization is a practical tool, especially in the banking finance segment and for a good reason. Banks tend to use this approach because it is easy to understand, especially when explaining the repayments to customers applying for loans or mortgages. Interest can be calculated easily, and this allows the borrower to be at ease once they understand the terms of the repayment and how the repayments have been calculated.