Amortization of premium refers to the practice of someone paying down the premium owed to a debtor in regular installments. Instead of simply paying off the interest of a loan in installments, this type of payment plan can significantly reduce the amount of premium owed at the end of the loan. Such a payment plan can be especially effective for lengthy loan paybacks like those found on mortgage agreements. In the world of bonds, amortization of premium refers to the accounting practice by which bond issuers account for the premium paid on certain bonds.
Loans are an integral part of the business world. They can be intricate transactions between large banks or they can be as simple as the mortgage agreements between lenders and home buyers. Many people tend to be concerned with a loan's interest rate, which is the percentage charged by the lender to compensate for the risk of taking on the loan. Paying back the original amount borrowed, also known as the premium, is just as important. Using the amortization of premium method can be an effective way for borrowers to meet their obligations.
As an example of how amortization of premium can be useful to borrowers, imagine that someone takes out a five year loan of $12,000 US Dollars (USD) with an interest rate of two percent. This means that the borrower must pay off interest at that rate each month, which comes to $240 USD per month. That still leaves the entire premium of $12,000 USD to be paid at the end of the five-year period.
One way to alleviate this bulk payment at the end of the loan is use amortization of premium. The borrower could conceivably pay off $200 USD per month in addition to his $240 USD interest payments. In the 60 months required to pay off the loan, the borrower would not only have taken care of his or her interest obligations in this manner, but would also have completely paid off the premium of the loan.
A bond is also a loan that is given by an institution like a government or a corporation to investors, who hope to benefit from the interest payments. When the amortization of premium is mentioned in concert with bonds, it is in reference to the accounting practices that the issuer must use. Bonds have a premium attached to them if they have interest rates that make them desirable to investors, who will then pay higher than the bonds' face value to get those favorable rates. To amortize the premium, the issuer must divide the premium received by the time it takes in years for a bond to mature and then debit the premium account in this amount each year.