You might have heard that a car loses most of its value the moment you drive off the lot. But that’s not the only type of buy that lessens in value over time. The concepts of amortization vs depreciation are a little nuanced but really important as you decide how to spend your money.
You should keep an eye on both amortization and depreciation because although they are "non-cash" expenses they can cost you a lot of your earnings.
Even though you may not be making an active payment, both amortization and depreciation are still direct costs. Keep in mind that an expense means money out of your pocket, no matter the reason.
So let's dig deeper into amortization vs depreciation and how they both really work.
Amortization definition
Amortization happens when you write off the starting value of an intangible asset over time. It often includes paying in increments over the asset's life, as the cost of an asset takes time to pay off or write off.
Amortization and assets
Most items don't last forever - even intangible (non-material) things. When it comes to assets, amortization essentially spreads an intangible asset's cost over the length of time it will be useful.
For instance, patents or software you purchase, copyright, and trademarks or trade names. You buy it now, but it will only last so long. The longer you have it, the less value it holds.
These assets usually don’t have any resale value at the end of their life.
Amortization and debt
From a lending perspective, you can show amortization in the form of an amortization schedule or table. An amortization schedule is usually used for understanding debt payments and is one of the differences when it comes to amortization vs depreciation.
It lists each monthly payment and breaks down how much of each payment goes to interest vs to principal.
The terms amortization and amortization schedule can easily be confused. The word "amortization" is used in both accounting and in lending. But it's important to keep in mind that the meaning and use of both terms are very different.
A good example of an amortization schedule is with a home mortgage. It shows you where all your money is going as you pay off your house.
Depreciation definition
Depreciation is defined as a reduction in the value of an asset with the passage of time, particularly due to wear and tear. Depreciating assets include the classic example of cars, as well as jewelry, clothes, equipment, and machinery.
For example, let's say you buy a new MacBook Pro for $1,300. If you only use it until the latest model comes out, it still has plenty of life in it.
You’ll likely be able to sell it, but for much less than you bought it at first. That difference in price shows its depreciation.
While your physical possessions will likely lose value over time—aka depreciate—most pieces still have some “salvage value” if you want to sell them. An asset's salvage value is its worth after it depreciates and is no longer functional. You can use a depreciation method called the straight-line method to find this.
Difference between amortization and depreciation
What are the key differences when it comes to amortization vs depreciation? After all, they seem almost the same, but they aren't.
The easiest way to explain the difference between amortization and depreciation is this: Amortization deals with intangible assets, and depreciation with tangible ones. For example, a car is a tangible asset, while a patent is intangible.
Calculating amortization vs depreciation
The calculation aspects of amortization and depreciation are different from each other. Check out the following ways to calculate amortization and depreciation.
Calculating amortization for assets
To calculate amortization on an asset, subtract the residual value of the asset from the original cost. Then divide that difference by the useful life of the asset.
It's a straight-line basis way of calculating amortization. It is also a simple way to determine the loss of value of an asset over time.
As time passes, subtracting the residual value from the original cost of the asset reduces the value of the asset each year. From a business perspective, this is recorded on the balance sheet in an account called "accumulated amortization".
Calculating amortization for debt
Amortization schedules are usually set up so you pay off your debt in equal installments. This structure is how lenders make money from interest over time.
For instance, let's say you pay $500 every month toward a loan. A small amount goes to the principal at first, with the main portion going toward your interest. The longer you make payments, the larger the percentage of the $500 goes toward your principal.
If you want to calculate amortization for a loan, try using a calculator like this one from Calculator.net.
Calculating depreciation
On the other hand, you calculate depreciation by subtracting the resale value of your physical asset from its original cost. You might also consider its potential usable lifetime.
For example, a single-use item like a paper cup would have a much steeper depreciation rate than a reusable glass cup. So even though the glass cup is a more expensive buy, it actually has a less expensive cost-per-use.
Another factor you should think about is maintenance. This is a big factor when it comes to amortization vs depreciation since only depreciating items need maintenance.
If you buy a highly specialized piece of equipment that’s built to last decades, the repairs could be expensive. You'd need to consider if it holds its value over time compared to its more standard competitor that’s cheaper to maintain.
How accelerated depreciation works
It’s also common (especially for businesses) to leverage accelerated depreciation. That means that they pay a larger portion of the asset's value upfront (the early years of the asset) in order to have a larger tax deduction earlier on. Higher costs = less revenue = less taxes.
Solar panels are a great way to see accelerated depreciation in action. Because you get tax credits from the eventual depreciation of your panels, you’re able to recoup that investment sooner after buying.
That equates to having more money back in your account to invest in other things. Even as your panels continue to depreciate as time passes.
Remember, you can also use the straight-line depreciation method to help you figure out how much value an asset has lost.
Intentional spending and preserving value
Value and time have a complicated relationship. That makes understanding amortization vs depreciation tricky.
You should think twice before becoming an investor in items that lose value over time. Instead, consider options that will, in theory, pay you back over time.
We’re talking about education, your health, real estate property, and the stock market. None of these come with certain gains, but at least they don’t come with certain losses!
Final thoughts on amortization vs depreciation
Amortization and depreciation may be hard to avoid. But at least now you’re aware of what they are and the difference between amortization and depreciation.
Stay intentional with your spending and consider all the factors that make up “value” before you buy. Think about things like defining needs and wants, and investable assets that can help you grow your wealth.