The financial world can be confusing. There are so many complex terms to understand and it can be difficult to feel confident about every financial decision when big terms are everywhere you look.
Fortunately, there are resources and people out there who can help you make sense of it all.
Understanding the difference between amortization and depreciation is a great place to start. Knowing the difference and the meaning of these terms can help you take another step to be financially confident!
What Is Amortization?
Amortization refers to the period of time used to repay a debt obligation gradually. A debt obligation is any form of credit or financing, such as a personal loan or a mortgage.
For example, a mortgage often has an amortization period of 30 years. This means you’ll repay the entire amount owing in 30 years.
In accounting, amortization specifically refers to spreading the cost of an intangible asset over its useful life. This could include the value of patents, franchise agreements, or even goodwill. Unless you’re an accountant, this reference to amortization isn’t commonly used.
What Is Depreciation?
Depreciation refers to the decrease in an asset’s value over time. Assets can depreciate over time.
For example, purchasing a new car is usually more expensive than purchasing a used car. This is because vehicles are depreciating assets, meaning they become less valuable over time. The more you drive your vehicle, the less value it holds.
Not all assets depreciate. Many properties, like houses, can appreciate in value over time. This depends on a few factors, but the asset itself can remain valuable over time.
How Do Amortization and Depreciation Compare?
Amortization and depreciation are similar because both terms refer to a change in value over time.
However, amortization refers to a fixed schedule or period of time where a borrower (person receiving funding through financing options) repays the value of the loan. Depending on what the loan was used for (like a mortgage), the borrower’s repayment plan is designed to help them own or purchase something that they normally couldn’t afford outright.
On the other hand, depreciation is usually not a controllable expense. Additionally, depreciation doesn’t necessarily have to be connected to a loan or liability. You could buy a brand new car in cash, but it will likely still depreciate over time.
Depreciation is a sunk cost, meaning it’s viewed as an expense that can’t be recuperated even if the asset is never used. Using our vehicle example, even if you purchase a new truck today and you don’t drive it for a year or longer, it will still depreciate.
With this same example, if you purchased a new truck today using a vehicle loan from your bank, that loan would have an amortization period agreed upon before you received your funding.
The Truck Example
Let’s say you purchased this new truck for $60,000 using a vehicle loan.
Assume your amortization period to repay this loan is 5 years. You would have to repay the entire amount of the loan over 5 years, which would work out to approximately $1,000 each month plus interest.
While you’re going to pay $60,000 (plus interest) over the next 5 years to own this truck, the value of the truck is going to decrease each year. The amount that your truck depreciates can depend on how much you drive it, any damage or accidents the truck is involved in, and other factors.
When you finish paying off your vehicle loan, your truck will be worth approximately 40% of its original value. So while you’ve paid the full $60,000 (plus interest) for your truck, and you now own it, it’s only worth about $24,000.
Why Does it Matter?
Understanding the difference between amortization and depreciation is not only important for understanding your loans and the value of your assets, but it’s also important so you can make informed buying decisions.
When we talk about a mortgage, a longer amortization can be “good” or “bad” depending on your needs and goals. A longer amortization period means you will pay more in interest over the life of your loan. However, your regular payments will also be lower and, in this case, you’re paying towards a property that can retain or even increase its value over time.
In the case of depreciation, there’s not much you can do to avoid depreciation. An asset will depreciate regardless of your best efforts. Vehicles are a great example because a vehicle is rarely worth more than its initial value as time passes.
One exception to this could be the example of classic cars. These vehicles are considered very valuable, sometimes even rare or collectible, and so the value of classic cars has appreciated over time.
This appreciation of a normally depreciating asset is linked to societal perception of value. We, as a society, believe that classic cars are valuable because they’re unique, aesthetically pleasing, and sometimes rare.
Again, this appreciation, like depreciation, is not within your control.
This isn’t to say that purchasing a brand new car or truck is “bad,” but it’s important to be aware of your expenditure before you sink a large sum of money into an asset that may not hold its value.
Similarly, it’s important to understand the amount you’ll pay towards a loan over the entire amortization period so you can properly budget and manage your financial assets.
Finances Don’t Have to be Confusing
We know this is a lot of information to take in all at once. As we know, financial terms and jargon can be confusing. We’re here to help you.
Whether you have questions about applying for a personal loan or payday loan, questions about your finances, or just need some advice on your financial situation, Blue Copper Capital is here for you. Contact us today!
