What Is Weighted Average Life?
A debt instrument’s weighted average life (WAL), which can be applied to loans, mortgages, and bonds, estimates when half of the principal will be repaid. It is calculated by dividing the weighted total payments by the unweighted total revenues.
The understanding 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. For loans, mortgages, and bonds, the weighted average life is frequently utilized.
- Alternate name: Average life
- Acronym: WAL
Let’s say, for illustration purposes, that a lender determined a WAL of 5.0 years for a current term loan. That means it would take five years to pay down half of the outstanding debt. The lender is at less danger the lower the WAL.
“While borrowers pay both main and interest towards the balance of their loan, only principal payments are included for determining the calculating the WAL,“ Viktor Viktorov, the CEO of REINNO, a commercial mortgage lender in Massachusetts, told The Balance in an email.
How To Calculate Weighted Average Life
The weighted total payments are divided by the unweighted total payments to determine the weighted average life. Viktorov used a 10-year bond with the following annual payments, which rise 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
The weighted average life on this 10-year bond is 7.05 years.If you add up the unweighted payments from year one to seven, it would total $27,500—about half of the total $54,500 outstanding principal.
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 principle payments are made at the conclusion of 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 the course of 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.
“Because weighted average life is dependent on principal payments, prepayments, or lack thereof, can make it shorter or longer,” Viktorov said.
For investors, prepayment offers certain pros and cons. “On the one hand, there is less interest income to be earned over the life of a debt instrument. This can create a problem for investors who depend on such income to make their own payments,” Viktorov said. “On the other hand, the likelihood of the total principal being repaid is increased.”
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 course of the loan, lenders might discourage prepayment. Before closing, borrowers should be informed of any prepayment limits put in place by lenders in order 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.