Weighted Average Life (WAL)

What Is Weighted Average Life (WAL)?

The weighted average life (WAL) is the average period of time that every dollar of unpaid principal on a loan, a mortgage, or a amortizing bond stays outstanding. Computing WAL shows an investor, an analyst, or a portfolio manager how it will require to receive generally half of the amount of the outstanding principal. The formula is valuable in measuring the credit risk associated with fixed-income securities.

Grasping Weighted Average Life (WAL)

The time weightings utilized in weighted average life calculations depend on payments to the principal. In many loans, for example, mortgages, every payment comprises of payments to principal and payments to interest. In WAL, just the principal payments are thought of and these payments will generally get bigger after some time, with early payments of a mortgage going for the most part to interest, while payments made towards the finish of the loan are applied for the most part to the principal balance of the loan.

Time spans with higher dollar amounts have more weight in WAL. For instance, if the majority of the repayment to principal is in 10 years, the weighted average life will be closer to 10 years.

Weighted Average Life Example

There are four steps engaged with ascertaining an amortizing bond's WAL. Expect a bond makes one payment each year. Throughout the next five years, the bond's payments are $1,000, $2,000, $4,000, $6,000 and $10,000. Accordingly, the total value of the (unweighted) payments before the WAL calculation is $23,000.

The initial step of the calculation is to take every one of these payments and duplicate them by the number of years until the payment happens. In this model, these values would be:

Year 1 = 1 x $1,000 = $1,000
Year 2 = 2 x $2,000 = $4,000
Year 3 = 3 x $4,000 = $12,000
Year 4 = 4 x $6,000 = $24,000
Year 5 = 5 x $10,000 = $50,000

The second step in the calculation is to add these weighted amounts together. In this model, the total weighted payments equivalent $91,000. Step three is to include the bond's total unweighted payments. In this model, the total is $23,000. The last step is to take the total weighted payments and gap this value by the total unweighted payments to get the WAL:

Weighted average life = $91,000/$23,000 = 3.96 years

In this model, WAL is generally equivalent to 4.00 and, toward the finish of four years, $13,000 of the $23,000 of principal is paid (somewhat the greater part). The biggest payment is the last payment, so the WAL is closer to the total five-year term of the bond. Then again, assuming year two and year five payments were exchanged, the weighted average life would be a lot of lower:

Year 1 = 1 x $1,000 = $1,000
Year 2 = 2 x $10,000 = $20,000
Year 3 = 3 x $4,000 = $12,000
Year 4 = 4 x $6,000 = $24,000
Year 5 = 5 x $2,000 = $10,000

Weighted average life = $67,000/$23,000 = 2.91 years

WAL gives investors or analysts a harsh thought of how rapidly the bond being referred to pays out returns. Since rational investors need to receive returns prior, assuming two bonds were compared, the investor would choose the one with the more limited WAL. Stated in an unexpected way, the most critical credit risk of a loan is the risk of loss of principal and a more modest WAL shows a higher probability that the principal will be repaid in full.

Features

Weighted average life doesn't consider payments to interest on the loan.
Most investors will choose the bond with the more modest WAL, as the lower number proposes that the bond conveys less credit risk.
Weighted average life is utilized to determine the dollar amount that stays outstanding on a mortgage or loan balance.
The calculation is "weighted" in light of the fact that it thinks about when the payments to the principal are made — if, for instance, practically the principal payments are all made in five years, WAL will be close to five years.