Amortization is an important concept for real estate investors to understand. When we first learned about amortization, it was confusing, but we had a great mentor explain it to us. And once we understood it, we were not only able to wrap our heads around how to finance a real estate deal through traditional means, but we were also able to structure complex creative finance deals involving subject to and seller financing.
So, let’s dive into what amortization is, and what real estate investors need to know about it.
What is Amortization?
Amortization as it relates to a loan on a real estate property describes “the process by which the principal amount of a mortgage is reduced with each payment.” When someone takes out a loan to purchase real estate, they are usually given an amortization schedule that tells them how much they need to pay each month in order to meet the interest requirements on the loan, as well as how much of that payment goes towards paying down the loan principal.
Amortization is also a term used to describe the distribution of expenses relating to “intangible items over the useful life of an asset.” This might sound like depreciation, but they are not one in the same (more on that later).
Amortizing A Loan
Amortization is the actual process “of gradually writing off the initial cost of an asset.”
An amortization schedule is the process of paying off a loan balance through payments overtime. Most of the time, initial payments towards a loan balance go primarily towards interest rather than decreasing the principal on the loan. The loan’s principal is paid off overtime.
The longer you go paying off a loan, the smaller the principal amount gets. This results in less interest being paid. But the total monthly payment does not change, just the direction of the money. Instead of going towards interest, the money goes towards decreasing the remaining principal, until the balance is paid in full.
In other words, as time passes and a borrower continues to make payments on a loan, “the proportion of the payment that goes to interest decreases, while the proportion that goes to paying off the principal increases.”
What’s The Difference: Amortization vs Depreciation?
Amortization involves intangible assets. For example, amortization may be applied to intangible assets like customer lists and contracts, software and technology, trademarks and brand names which a new real estate business spent money on before having an active rental. In a startup like this one, costs can be amortized if they are higher than $5,000 or if they are costs incurred during refinancing or property renovations.
If a real estate business incurs $10,000 in expenses on intangible assets, they may deduct $5,000, and amortize the rest of it over time. Or, they can amortize all $10,000 over the same time period.
In contrast, depreciation involves tangible assets. This includes things like “building equipment, office furniture, [and] machinery.” Depreciation is calculated by taking the cost of an asset, subtracting the salvage value, and then dividing this by the useful life of the asset. See below for a visual.
Before we get into positive and negative amortization, let’s define what a fully amortized loan is. This type of loan means that the entire balance on a loan will be paid in full once the term is complete, assuming the borrower made every scheduled payment.
+/- Amortization
Positive amortization involves the gradual paying off of a principal balance on a loan as you make monthly payments overtime. But this isn’t the only kind of amortization. With most lenders, borrowers are required to pay back a portion of the principal with each monthly payment they make in order to reduce the lender’s risk. This decreases the loan balance with each installment payment.
Negative Amortization, which involves a principal balance that increases, when your monthly payments aren’t enough to cover the costs related to interest. So, the unpaid interest builds like bacteria, and is added on top of the principal amount owed. This spiral results in an increase in the total amount owed.
Negative amortization is seen in loans with an adjustable rate. If an investor underwrites at a certain interest rate, but the adjustable rate rises higher than the investor anticipated, they won’t be able to cover their payments. The difference will be added to the remaining balance.
Balloons Aren’t Just For Kids
Balloon payments are often used when it comes to commercial real estate loans. For example, a property might be purchased with a 10-year loan with a fixed interest rate, but it’s amortized over a timeline of 20-25 years. The loan is due after 10 years. Once time is up, the investor must pay the remaining principal balance completely. An investor can choose to sell or refinance. Since the loan is amortized over 25-30 years, the monthly payment the investor makes during the 10 years is smaller, which means the investor spends less money each month, allowing for more cash flow, and increasing their Return On Investment.
Debt Is Your Friend
Amortization is an essential concept, because debt is at the core of how real estate investors make deals happen. Debt is also something that is widely feared and misunderstood. But the savviest and most successful investors understand the power of debt - as long as it is used correctly.
After reading this article, we hope you’re a few steps closer to using debt as a tool to reach your real estate investing goals.