What Does Depreciation Mean?
Depreciation not only impacts business owners but the average consumer as well.
Contributing Writer at Tally
April 26, 2021
Depreciation is a term used to recognize the loss in value of an asset. An asset is anything that you may own, such as your car or television. Depreciation is most commonly used as an accounting term for business owners, but it can apply to personal finance.
In this article, we’ll cover:
What is depreciation?
Different types of depreciation.
Why depreciation matters for personal finance.
What Is Depreciation?
Depreciation is the measurable loss in the value of an asset. Assets depreciate until their value is $0. A good example of depreciation is buying a new car.
Let's say that you buy a new car, which is an asset. You pay in cash. The purchase price of the car is $30,000. As soon as you drive the car off the lot, the car loses value. Within the first year of ownership, the car will lose 15-20% of its value. After a year, the car that you bought for $30,000 is now only worth $24,000.
Every year thereafter, the car will lose an additional 15% of its value. This is known as the rate of depreciation. After five years, the car will be worth just 20% of the original cost. Cars tend to lose most of their value in the early years of ownership.
Where depreciation differs between businesses and personal finances is taxes. The IRS allows business owners to use depreciating assets as tax deductions, meaning they can write off depreciation expenses on their tax returns. Individuals, however, cannot write off depreciation for income tax purposes.
This means that while there is a benefit to depreciation for small business owners, as it can reduce their taxable income, there is no such benefit to individuals who don’t own a business.
How Can I Calculate Depreciation?
Accountants typically use three methods to calculate depreciation rates. All three methods require a few inputs to get started:
The useful life of the asset: This is the period in which the asset is productive. In other words, it's the life span of the asset or the number of years it's in use. When the useful life expires, the asset is no longer operational.
Salvage value: After the useful life of the asset has expired, businesses may consider selling it. Any money made in this sale is known as the salvage value.
The asset’s cost: This includes the principal cost of an asset and the taxes, shipping and setup expenses associated with it.
The residual value of the asset: This is the estimated value of a fixed asset at the end of its life span.
Once bookkeepers have these inputs, they can calculate depreciation using one of these methods:
1. Straight-line depreciation method
When calculating your personal assets, you’ll likely use the straight-line method. You may want to calculate depreciation when determining the resale value of an asset.
This method recognizes the same amount of depreciation every year over the life span of the asset. The depreciation rate is the same in the early years and later years of ownership.
Annual Depreciation Expense = (Asset Cost - Residual Value) / Useful Life of the Asset
2. Unit of production method
This is not very applicable to personal financial situations, though it’s helpful for businesses that manufacture products.
Units of production depreciation assign a depreciable value to each unit produced. To start, calculate the per-unit depreciation.
Per Unit Depreciation = (Asset Cost - Residual Value) / (Useful Life in Units of Production)
Next, calculate the total depreciation.
Total Depreciation Expense = Per Unit Depreciation * Number of Units Produced
3. Double-declining balance method
The double-declining method is a bookkeeping strategy used in depreciation calculations when an asset loses value quickly, like a new car.
This method is also referred to as the accelerated depreciation method because it counts expenses on the balance sheet twice as much as the book value of the asset.
Start by calculating the book value.
Book Value = Cost of the Asset - Accumulated Depreciation
Then, use the formula:
Depreciation = 2 * Straight Line Depreciation Percentage * Book Value at the Beginning of the Accounting Period.
Why Does Depreciation Matter For Personal Finances?
Depreciation is important for business owners, but why should it matter for the average consumer who does not own a business?
The answer is because taking on debt to pay for a depreciating asset can have tremendous financial implications. In essence, you're borrowing money to pay for something that's losing value over time. However, because of interest, you're paying more than what the asset is worth.
This concept, of course, is the societal norm. For instance, it's common practice in real estate to take out a mortgage to pay for a home. You may take out an auto loan to purchase a new car.
How Does Depreciation Apply To Credit Card Purchases?
The downside of depreciation is clearer when looking at credit cards. Let's say, for instance, your television breaks. You have $500 in your bank account that you can use to buy a new one. But the model that you want costs $1,200. So, you put this expense on your credit card.
However, because you don't have the cash needed to pay off your credit card balance, you begin accumulating interest. Credit card interest is risky because of its high rate. Before you know it, your $1,200 TV could cost you $1,500, with the additional $300 coming from interest.
During this time, the TV depreciates. As soon as you took it home and plugged it in, it became less valuable than when you purchased it. You may be able to resell it on a third-party market, but probably not for the original amount that you paid. And, if you do sell it, you’re still obligated to make the credit card payment, plus any interest you accumulate.
Credit cards can be useful tools, offering things like cash-back rewards or travel points. They can help you build your credit score so that if you have to borrow money, your lender can offer you the best rate available. But they are most useful if you pay your balance in full each month.
What Can I Apply Depreciation To My Personal Finances?
Now that you understand depreciation and how it applies to your personal finances, you can take some measures to improve your situation. As mentioned, you should try to avoid using a credit card for large purchases unless you know that you can pay it in full. Instead of purchasing a top-of-the-line item that you need to borrow money to buy, consider a more affordable item that you can pay off immediately.
Similarly, consider using cash for your purchases. Paying with cash or a debit card ensures that you don’t overspend on a credit card, as you’re only using funds that are currently in your bank account.
If you currently carry credit card debt, consider a credit card payoff app like Tally. Tally automatically pays your credit cards in the most efficient way possible, helping you get out of debt and improve your cash flow.
Be Mindful Of Depreciation When It Comes To Personal Finances
Though accountants and business owners commonly use depreciation, it has its place in personal finances. Depreciation is a broad term that represents what occurs whenever an asset loses value. This act occurs over time, throughout the life span of the asset.
Depreciation impacts personal finances because people often borrow money to make large purchases. Some of these purchases, like a home, are more necessary than others. However, using a credit card to buy depreciating assets generally isn’t advisable. Doing so means you’re paying interest for an asset that is losing value.
Paying your balance in full each month or using cash for purchases are sound methods to avoid this. But if you already find yourself carrying credit card debt, try checking out Tally.