A debt instrument’s weighted average life (WAL), which can be applied to loans, mortgages, and bonds, is an estimation of when half of the principal will be repaid. By dividing the weighted total payments by the unweighted total payments, it is calculated.
The understanding of weighted average life has advantages for investors as well as borrowers. To find out how to calculate it and put it to use, continue reading.
Definition and Examples of Weighted Average Life
A debt instrument’s weighted average life is an estimation of how long it would take to pay off halves of its principal sum, such as on a loan, mortgage, or bond. Divide the weighted total payments by the unweighted total payments to determine the weighted average life of a loan. Most often, weighted average life is employed for loans, mortgages, and bonds.
- Alternate name: Average life
- Acronym: WAL
Take the case of a lender that determined a WAL of 5.0 years on an active-term loan. That means it would take five years to pay off half of the main balance that is still owed. The risk to the lender decreases as the WAL decreases.
According to Viktor Viktorov, CEO of REINNO, a Massachusetts-based commercial mortgage lender, “although borrowers make principal and interest payments towards their loan total, only principal payments are taken into account for computing the WAL.”
How To Calculate Weighted Average Life
By dividing the weighted total payments by the unweighted total payments, the weighted average life is determined. Viktorov used a 10-year bond with annual payments that are increasing annually as an example.
|10-Year Bond Annual Payments|
The weighted payments are calculated by multiplying the unweighted amount by the year it is paid. In Year 1, for example, the weighted payment is $1,000 ($1,000*1). In Year 8, the weighted payment is $64,000 ($8,000*8).
Next, sum up the unweighted payments and weighted payments.
Unweighted Sum: $1,000 + $1,500 + $3,000 + $4,000 + $5,000 + $6,000 + $7,000 + $8,000 + $9,000 + $10,000 =$54,500
Weighted Sum: $1,000 + $3,000 + $9,000 + $16,000 + $25,000 + $36,000 + $49,000 + $64,000 + $81,000 + $100,000 = $384,000
To calculate the weighted average life on this bond, divide the total weighted payment by the total unweighted payment: $384,000 / $54,500 = 7.05
This 10-year bond has a weighted average life of 7.05 years. The total unweighted payments from years one through seven would come to $27,500, or approximately half of the $54,500 total principal still owed.
Say you swap the payments for Years 2 and 9 using the aforementioned example. In Year 2, the updated weighted payments increase to $18,000 from $3,000, and in Year 9, they decrease to $13,500 from $13,500. The WAL would be reduced from 7.05 years to 6.08 years with only one change.
The WAL is typically brought closer to maturity when larger principal payments are made after the loan, according to Viktorov. The WAL was shortened and moved farther away from maturity when we shifted the greater payment to an earlier year.
How Does Weighted Average Life Work?
To evaluate the risks connected to particular debt instruments, weighted average life is frequently utilized. Loans with shorter WALs are less risky and provide investors with faster returns because principal loss is less likely to occur. They can then reinvest earlier as a result. A shorter WAL, however, also lowers the potential interest earnings for investors throughout a loan.
In contrast, a longer WAL is viewed as riskier because the borrower has more time to stop making payments on the loan. Risk-averse investors may be intimidated by this, but it may also draw risk-takers who will be able to demand higher interest rates and, in the long term, earn larger returns, according to Viktorov.
“Prepayment, or lack thereof, might make the weighted average life shorter or longer,” Viktorov added. This is because the weighted average life is based on the principal payments made.
Prepayment has some advantages and disadvantages for investors. “On the one hand, earning interest throughout a debt instrument is less likely. Investors who rely on such money to make their payments may experience difficulties as a result, according to Viktorov. On the other hand, there is a higher chance that the entire principal will be paid back.
What It Means for Borrowers
By paying the loan off early or refinancing at a cheaper interest rate, the borrower may benefit by shortening the WAL.
However, because they lose money on interest payments throughout the loan, lenders might discourage prepayment. Before closing, borrowers should be informed of any prepayment limits put in place by lenders to reduce this risk, according to Viktorov. For instance, if a borrower pays off their mortgage before it matures, the mortgage lender may assess a prepayment fee.
Always read the small print before signing any loan documents. Check for prepayment penalties that may apply if you pay off all or a portion of your loan early.