Alternate name: Average lifeAcronym: WAL
For example, let’s say a lender calculated a WAL of 5.0 years on an outstanding term loan. That indicates it would take five years for half of the outstanding principal amount to be repaid. The lower the WAL, the lower the risk for the lender. “While borrowers make principal and interest payments towards their loan balance, only principal payments are taken into account when 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
Weighted average life is calculated by dividing the weighted total payments by the unweighted total payments. Viktorov provided an example using a 10-year bond with the following annual payments, which increase every year: 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. Using the above example, let’s say you swap the payments for Year 2 and Year 9. The updated weighted payments are $18,000 in Year 2, up from $3,000 and $13,500 in Year 9, down from $13,500. This single switch would shorten the WAL to 6.08 years from 7.05 years. “In most cases, bigger principal payments are made towards the end of the loan, making the WAL closer to maturity," Viktorov said. When we moved the larger payment to an earlier year, it shortened the WAL, bringing it further away from maturity.
How Does Weighted Average Life Work?
Weighted average life is commonly used to assess the risks associated with certain debt instruments. The principal loss is less likely for loans with a shorter WAL, which means they are less risky and that investors get their returns faster. In turn, they can reinvest earlier. However, a shorter WAL also reduces the amount of interest investors could potentially earn over the life of a loan.” Conversely, a longer WAL is considered riskier since the borrower has more time to default on the loan. “This will intimidate risk-averse investors but can attract risk-seekers who can demand higher interest and receive higher returns in the long run,” Viktorov said. “Since weighted average life is based on the payments made towards the principal, prepayment, 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
It can be beneficial for the borrower to shorten the WAL, by prepaying or refinancing at a lower interest rate. Lenders, however, may discourage prepayment because they lose profit in interest payments over the loan term. “To avoid this risk, lenders can implement some prepayment restrictions that borrowers should be aware of before closing,” Viktorov said. Mortgage lenders, for example, may charge a prepayment fee if a borrower repays their mortgage before maturity. Before signing any loan agreement, always read the fine print. Look for prepayment fees that could penalize you for paying off all or part of your loan early.
