What Is Weighted Average Life (WAL)?
Let me explain Weighted Average Life, or WAL, directly to you. It's the average time that each dollar of unpaid principal on loans, mortgages, or amortizing bonds stays unpaid. As an investor or analyst, you use this to gauge credit risk by estimating how long it takes to recover half of the outstanding principal. Unlike simple interest or basic amortization, WAL zeros in on principal payments alone, making it a crucial tool for analyzing fixed-income securities.
How Weighted Average Life (WAL) Impacts Loan Repayment
You need to understand that WAL's time weightings come from principal payments. In loans like mortgages, payments split between principal and interest, but WAL only counts the principal part. These principal payments grow larger over time—early on, most of your payment goes to interest, while later payments hit the principal harder.
Periods with bigger dollar amounts carry more weight in the WAL. For instance, if most principal repayment happens in 10 years, your WAL skews closer to 10 years.
Example Calculation of Weighted Average Life
Here's how you calculate WAL for an amortizing bond—I'll walk you through it step by step. Assume the bond pays yearly over five years with payments of $1,000, $2,000, $4,000, $6,000, and $10,000. The total unweighted principal is $23,000.
First, multiply each payment by its year: Year 1 is 1 x $1,000 = $1,000; Year 2 is 2 x $2,000 = $4,000; Year 3 is 3 x $4,000 = $12,000; Year 4 is 4 x $6,000 = $24,000; Year 5 is 5 x $10,000 = $50,000. Add them up to $91,000.
Then, divide that by the total unweighted payments: $91,000 / $23,000 = 3.96 years. So, WAL is about 4 years, and by year four, you've paid $13,000 of the $23,000—over half. The big final payment pulls the WAL toward the five-year mark.
Switch year two and five payments, and it changes: Year 1 = $1,000; Year 2 = 2 x $10,000 = $20,000; Year 3 = $12,000; Year 4 = $24,000; Year 5 = 5 x $2,000 = $10,000. Total weighted is $67,000, so WAL = $67,000 / $23,000 = 2.91 years.
WAL gives you a sense of how fast the bond returns principal. As a rational investor, you'd pick the one with the shorter WAL for quicker returns. Put simply, credit risk centers on losing principal, and a shorter WAL means higher chances of full repayment.
The Bottom Line
To wrap this up, WAL measures the average time for principal to remain outstanding, it's vital for evaluating credit risk, and it guides investors toward lower-risk options with faster repayments. This breakdown simplifies the concept so you can apply it confidently in your financial decisions.
Key Takeaways
- Weighted average life (WAL) measures the average time each dollar of unpaid principal on a loan or bond remains outstanding.
- WAL calculations consider only payments to principal, not interest, highlighting the timing of these payments.
- A bond with a shorter WAL is generally preferred due to its lower credit risk, suggesting quicker principal return.
- WAL provides insight into the time it takes for approximately half of a bond's principal to be repaid.
- Calculating WAL involves a weighted sum of payments against the number of payment years, offering a measure of credit risk for fixed-income securities.
Other articles for you
A parent company is a business entity that holds controlling interest in subsidiaries, providing oversight while allowing operational autonomy.
This text explains the fundamentals of supply chains, from components and models to best practices and impacts like COVID-19.
Economic depreciation measures the decline in an asset's market value due to external economic factors, differing from scheduled accounting depreciation.
Dividend recapitalization is a strategy where companies take on new debt to pay special dividends to investors, often used by private equity firms for early returns.
The Parabolic SAR is a technical indicator used to identify trend directions and potential reversals in asset prices.
A Deferred Profit Sharing Plan (DPSP) is a Canadian employer-sponsored retirement savings plan where employers contribute profits to help employees build tax-deferred retirement funds.
Gross income represents total earnings before deductions for individuals and revenue minus cost of goods sold for businesses.
A liquidity event enables founders and early investors to convert illiquid equity into cash through actions like IPOs or acquisitions.
A volume discount reduces prices for buyers purchasing in large quantities to encourage bulk sales.
The Accredited Asset Management Specialist (AAMS) is a professional certification for financial advisors focusing on asset management and personal finance.