Amortisation in Accounting refers to the systematic allocation of intangible asset costs (patents, software licences, goodwill) over their useful life. For example, a £50,000 software licence with a 5-year life would be amortised at £10,000 annually, providing ongoing tax relief.
Amortisation for Loans is the process of paying off debt through regular, fixed payments that cover both the borrowed amount (capital) and interest charges. Here’s what makes it brilliant: because interest is calculated only on the remaining balance, each payment reduces what you owe, which means less interest next time. Early payments are mostly interest because you owe the full amount, but as the balance shrinks, more of each payment goes toward clearing the debt itself.
How Loan Amortisation Works
Loan amortisation works on a simple principle: each payment consists of capital repayment plus interest on the outstanding balance. The key insight – interest is only charged on the capital you still owe, not the original loan amount.
Amortisation Calculation
The standard formula for fixed periodic payments: PMT = P × [r(1+r)^n] / [(1+r)^n – 1]
Business Example: £250,000 equipment loan at 6% annual rate over 5 years
- Monthly rate: 0.5% (6%÷12)
- Total payments: 60 (5×12)
- Monthly payment: £4,833.42
Payment Evolution:
- Month 1: £1,250 interest + £3,583 principal
- Month 36: £663 interest + £4,170 principal
- Month 60: £24 interest + £4,809 principal
Key Results:
- Total interest paid: £40,005 (16% of loan amount over 5 years = ~3% per year)
- This means you’re effectively paying just 3% annually in interest costs – far less than the 6% rate might suggest
- Early payments: ~26% principal, ~74% interest
- Later payments: ~99% principal, ~1% interest
Excel Function: =PMT(0.5%, 60, 250000) = £4,833.42
Key Takeaway
With amortising loans, the true total interest cost is roughly half what the stated rate implies. This occurs because you progressively reduce the outstanding balance with each payment, meaning interest calculations are based on a diminishing principal amount throughout the loan term.
Types of Business Loans and Amortisation
Fixed-Rate Loans maintain the same interest rate throughout, making payments completely predictable and protecting against rising rates.
Variable-Rate Loans (Tracker Loans) follow the Bank of England base rate plus a margin. Payment amounts fluctuate with rate changes, but the amortisation principle remains the same
Interest-Only Loans require only interest payments during the term, with full principal due at maturity – these don’t follow traditional amortisation.
Benefits of Loan Amortisation
Lower True Interest Costs – amortised loans cost far less than most people expect. While borrowers might anticipate paying 6% interest annually on the full loan amount each year (£15,000 × 5 years = £75,000 total), the actual total interest paid is typically around half that expectation due to the declining balance structure of amortisation.
For Borrowers – predictable monthly payments enable straightforward budgeting, each payment builds equity, and you can save more through extra principal payments. Regular payments also build credit history.
For Lenders – reduced risk as outstanding balance decreases, steady income stream, and easier creditworthiness assessment.
Tax Benefits – loan interest is fully deductible against Corporation Tax. A business paying £10,000 in annual interest saves £2,500 in tax at 25% rate, reducing real borrowing cost to £7,500.
We break down more financial jargon on our “What is…?” blogs at Funding Bay.
