Definition and Examples of Weighted Average Life
The Weighted Average Life (WAL) – which can be used for loans, mortgages, and bonds – refers to an estimate of when half of the principal owed on a debt instrument will be repaid. The weighted average life indicates the duration of time it takes to repay half of the principal amount due on the loan. To calculate the weighted average life, the total weighted payments of the loan must be divided by the total unweighted payments. The weighted average life is typically used to assess the risks and profitability of investments such as loans and debt instruments.
How to Calculate Weighted Average Life
The weighted average life is calculated by dividing the total weighted payments by the total unweighted payments. An example of a 10-year bond can illustrate the calculation method. The weighted payments are computed by multiplying the unweighted amount by the year in which the payment is made. For instance, in the first year, the weighted payment is $1000 (1000 * 1). In the eighth year, the weighted payment is $64000 (8000 * 8). After that, the unweighted payments and weighted payments are summed. To calculate the weighted average life of this bond, the total weighted payments must be divided by the total unweighted payments. After computation, it is found that the weighted average life of this 10-year bond is 7.05 years.
How Does Weighted Average Life Work?
The weighted average life is typically used to assess the risks associated with certain debt instruments. The loss of capital is less likely in loans with a shorter weighted average life, meaning they are less risky, and investors receive returns faster. In turn, they can reinvest sooner. However, a shorter weighted average life also reduces the amount of interest that investors can potentially earn over the life of the loan. On the other hand, a longer weighted average life is considered riskier as the borrower has more time to default on the loan. “This might intimidate investors who fear risks, but it may attract investors looking for risks who can demand higher returns and achieve greater returns in the long term,” said Victor Viktorov, CEO of REINNO, a commercial lending company in Massachusetts, in an email to The Balance.
What Does It Mean for Borrowers?
It may benefit borrowers to shorten the weighted average life by repaying the amount due early or refinancing at a lower interest rate. However, lenders might discourage early repayment as they lose profit on interest payments over the life of the loan. “To mitigate this risk, lenders may implement certain restrictions on early repayment that borrowers must be aware of before closing,” according to Victor Viktorov. For example, mortgage lenders may impose fees for early repayment if the borrower pays off the mortgage before maturity. Always read the fine print before signing any loan agreement. Look for early repayment fees that could penalize you for paying off all or part of your loan early.
Source: https://www.thebalancemoney.com/what-is-weighted-average-life-5212723
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