What Exactly Is an Amortized Bond?
An amortized bond is one in which, during the bond’s existence, both the principle (or face value) of the loan and the interest expense are routinely paid down. One such example is a fixed-rate home mortgage, where the monthly payment is fixed throughout the course of, say, 30 years. However, the proportion of interest and principal in each payment varies somewhat. An amortized bond differs from a balloon or bullet loan in that a significant amount of the principal must only be returned after the bond reaches maturity.
Getting to Know Amortized Bonds
An amortization schedule divides the principal paid down throughout an amortized loan or bond into equal installments at regular intervals, as is common. This implies that the interest component of the debt payment will be more than the principal portion in the early years of a loan. However, when the loan matures, the amount of each payment that goes toward interest will decrease, and the amount paid toward the principal will increase. Utilizing an amortization calculator, rapid calculations for an amortizing loan may be made that are comparable to annuity calculations utilizing the time value of money.
Two essential risks associated with bond investment are impacted by debt amortization. The principle of the loan is repaid over time rather than all at once upon maturity, when the risk of default is at its highest, considerably reducing the credit risk of the loan or bond. Compared to comparable non-amortized debt with the same term and coupon rate, amortization shortens the bond’s length and lowers the debt’s sensitivity to interest rate risk. This is due to reduced interest payments over time, which results in a shorter weighted-average maturity (WAM) of the bond’s related cash flows.
A Bond Amortization Example
Mortgages with 30-year fixed rates are amortized such that the principal and interest are paid off each month. Suppose you borrow $400,000 over 30 years at 5% interest to buy a house. $2,147.29 is the monthly payment, or $25,767.48 annually.
After the first year, you have made 12 payments, most of which have been used to pay interest. Only $3,406 of the principal has been paid off, leaving $396,593 on the loan. The principal pay climbs to $6,075 the next year, but the monthly payment amount stays unchanged. Imagine yourself in year 29, when the principal balance will be $24,566, or nearly all of the $25,767.48 in yearly payments. Online calculators that are free to use, such as amortization or mortgage calculators, can aid with these calculations fast.
Effective-Interest Method of Amortization vs. Straight-Line Amortization
Companies that issue bonds employ the accounting technique of treating a bond as an amortized asset. The bond discount may be treated as an asset by the issuer during the bond’s duration up to its maturity. When a corporation sells a bond for less than its face value, it is said to be sold at a discount, and when more money is paid than the bond is worth, it is said to be sold at a premium.
A bond must be classified as an expense or an asset when it is issued at a discount or sold for less than its face value or par. As a result of the amortized bond discount being accounted for as part of an organization’s interest expenditure on its income statement, an amortized bond can be utilized expressly for tax purposes. A company’s earnings before tax (EBT), a non-operating cost, are decreased by interest costs, lowering its overall tax burden.
Effective-interest amortization and straight-line amortization are the two methods for amortizing bond premiums or discounts. Using the straight-line amortization technique is the simplest approach to account for an amortized bond. According to this accounting technique, the bond discount is equalized over the bond’s life and amortized annually.
Companies may also employ the effective-interest technique and issue amortized bonds. Effective interest computes various amounts to be applied to interest cost for each period instead of allocating an identical amount of amortization. This second method of accounting bases the amortization of the bond discount on the difference between interest payable and revenue from interest on the bond. You’ll need a financial calculator or spreadsheet program to calculate using the effective-interest approach.
- Each payment on an amortized bond is applied to the principal and interest.
- A large portion of each payment will go toward interest in the early phases of the loan, and a larger amount will go toward principle in the latter stages.
- An illustration of an amortized loan is a 30-year fixed-rate mortgage.
- An amortization schedule is utilized to determine how much of each bond payment is principal and how much is interest.
- Bond premiums and discounts are amortized using straight-line and effective interest accounting techniques.