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 purchase that dwindles in value over time. The concepts of amortization vs depreciation are a little nuanced, but really important as you decide how to spend your hard-earned money.
You should keep an eye on both amortization and depreciation because although they are “non-cash expenses they can cost you a lot. Even though you may not be making an active payment, both amortization and depreciation are still direct expenses. Keeping in mind that an expense means money out of your pocket, no matter the reason.
If you are an entrepreneur, the upside is that you might be able to use these unintentional expenses as a deduction to reduce the load of your business taxes.
That being said, let's dig into deeper into amortization vs depreciation and how they both really work.
What is amortization?
Amortization and assets
Most things are not made to 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, and trademarks, or software you buy. You buy it now but it has a finite lifespan. The longer you have it, the less value it holds. These assets generally don’t have any resale value at the end of their lifespan.
Amortization and debt
Amortization is also used from a lending perspective in the form of an amortization schedule or table. An amortization schedule is typically used for calculating debt payments. 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 since the word "amortization" is used in both accounting and in lending. But it's important to keep in mind that the definition and use of both terms are very different.
What is depreciation?
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 originally. 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.
Calculating amortization vs 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. This is a straight-line basis way of calculating amortization. It is also the simplest 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 typically 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.
On the other hand, depreciation is calculated 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 club. So even though the glass cup is a more expensive purchase, it actually has a less expensive cost-per-use.
Another factor you should think about is maintenance. If you buy a highly specialized piece of equipment that’s built to last decades, the repairs could be insanely expensive. You'd need to consider if it holds its value over time compared to its more standard competitor that’s cheaper to maintain.
It’s also common (especially for businesses) to leverage accelerated depreciation. This means that they pay a larger portion of the asset's value upfront in order to have a larger tax deduction earlier on. Higher expenses = 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 purchasing. 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.
Intentional spending and preserving value
Value and time have a complicated relationship. That makes understanding amortization vs depreciation tricky.
You should think twice before investing in items that lose value over time. Instead, consider options that will theoretically pay you back over time. We’re talking about education, your health, real estate property, and the stock market. None of these come with guaranteed gains, but at least they don’t come with guaranteed losses!
You might not be able to avoid amortization and depreciation. But at least now you’re aware of what they are and how they work. Stay intentional with your spending and consider all the factors that makeup something’s “value” before you buy.