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What is Amortization in Banking?

Amortization is the elimination of debt by repaying it on periodic payments. This payment covers the interest levied on the principle amount along with the principle amount as long as, you pay the periodic installment.

Sep 18, 2015 16:14 IST
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Amortization is the elimination of debt by repaying it on periodic payments. This payment covers the interest levied on the principle amount along with the principle amount as long as, you pay the periodic installment.

Similarly, Amortizing Bond is a bond that pays back a fraction of the principal value along with coupon payments. An amortizing loan should be impaired with the bullet loan, where a large portion of the loan will be conferred at the last maturity date instead of being paid down gradually over the loan period.

Impacts of Amortization: -  Amortization of debt has two major impacts:

  1. Interest Risk: -  Amortization cuts the duration of debt and reduces the debt’s susceptibility to the interest rate risk, as compared to debt of the same maturity and coupon rate. That’s why, there are small installments in future due to its low flow of weighted –average maturity of cash flow.

Now here question arises, What is weighted average maturity? How it is calculated?

“The number weighted average of the times of the principal repayments  of an amortizing loan is known as weighted average maturity.”

Credit Risk: -  It reduces the credit risk of the loan and debt substantially. By paying off the principal over time, The risk is minimized.

Amortization almost bears an asset’s expense with the revenue it generates.

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