Fixed Amortization Method

What is the Fixed Amortization Method?

The fixed amortization method of determining substantially equal periodic payments is probably the most popular method out of the three available.  Its popularity stems from the fact that it is simple to calculate and also creates a wide ranges of possible annual payments.

The annual payment is derived by amortizing the account balance over a pre-determined number of years using the selected life expectancy table(uniform, single life, or joint and survivor) and interest rate that you choose.  Once the annual payment is determined for the first year, it stays fixed for the remainder of the plan.

Choosing the Appropriate Interest Rate

While you cannot just go and use any interest rate you want to, the rules around choosing one are fairly flexible.  The IRS states that you cannot use an interest rate that is over 120% of the federal midterm rate for the two months prior to taking the distribution.  Link to IRS Interest Rate Card.  Remember, that higher rates produce higher payments.

How do I Determine The Account Balance To Use?

The account balance part of the equation can be derived using the same rules as that of required minimum distributions.  You can either use the balance of your account from the last day of the prior year or you can use a date "within a reasonable period" prior to the distribution date.  The accout valuation on both of these dates could be drastically different if the market was swinging wildly in that time period.

Calculating Your Annual Payment

Calculating your fixed amortized payment is exactly the same as calculating your mortgage.  In our case, the mortgage balance is equal to our account balance.  The interest rate on the mortgage is equal to the interest rate we discussed above and the term of the mortgage (ie. 30 years) equates to our number of years from the life expectancy table.  The New York Life website has a great calculator which can easily help you determine this number. 

Advantages of Fixed Amortization Method

The advantages of using the fixed amortization method of determining substantially equal periodic payments is simple to use in the sense that you only calculate your annual payments 1 time and then that amount is the same every year.  Secondly, there is flexibility in the interest you use and thirdly, you are allowed to use any of the three life expectancy tables.  The name of this method should be flexible amortization.

Disadvantages of Fixed Amortization Method

The major drawback of this method is that the payment is constant.  Since it can only be calculated once, it will not take into account many items such as investment returns, changes to life expectancy, or items like inflation.  Just think of our current situation where inflation is going through the roof with these high gas and food costs.  Fixed amortization would not allow you to make adjustments to account for this.

Tim Ord
Ord Oracle

Tim Ord is a technical analyst and expert in the theories of chart analysis using price, volume, and a host of proprietary indicators as a guide...
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