Understanding Weighted Average Life Calculation: A Comprehensive Guide

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What Is Weighted Average Life (WAL)?

Weighted average life (WAL) is a financial metric used to determine the average time it takes for each dollar of unpaid principal on a loan or mortgage to be repaid. It is an essential calculation for investors and lenders to assess the risk and profitability of their investments.

How Does Weighted Average Life Work?

The calculation of weighted average life involves taking into account the remaining outstanding principal amount and the time it takes for each payment to be made.

Example of Weighted Average Life Calculation

Let's consider a mortgage with the following details:

Principal amount: $100,000
Interest rate: 5%
Term: 30 years

Using the weighted average life formula, we calculate the time it takes for each dollar of unpaid principal to be repaid:

Weighted Average Life = Sum of (Principal x Time) / Sum of Principal

For each year, we calculate the outstanding principal amount and multiply it by the corresponding time:

Year 1: $100,000 x 1 = $100,000
Year 2: $99,723 x 2 = $199,446
Year 3: $99,443 x 3 = $298,329
...
Year 30: $0 x 30 = $0

Summing up the products and dividing it by the sum of the principal amount:

Weighted Average Life = ($100,000 + $199,446 + $298,329 + ... + $0) / $100,000

This calculation gives us the average number of years it takes for each dollar of unpaid principal to be repaid, taking into account the declining principal balance over time.

Key Takeaways

- Weighted average life (WAL) is the average number of years for which each dollar of unpaid principal on a loan or mortgage remains outstanding.

- The calculation of weighted average life takes into account the remaining outstanding principal amount and the time it takes for each payment to be made.

- By calculating the weighted average life, investors and lenders can assess the risk and profitability of their investments.

Understanding Weighted Average Maturity (WAM)

Weighted average maturity (WAM) is another financial metric used to assess the average time it takes for a portfolio's securities to mature. While similar to weighted average life, WAM considers the maturity of a portfolio rather than unpaid principal.

Example of How WAM Is Computed

Weighted average maturity is calculated by taking into account the time until each security in the portfolio matures and weighting it by the amount invested in each security. The calculation is similar to the weighted average life formula.

Weighted Average Maturity vs Weighted Average Loan Age

Weighted average maturity and weighted average loan age are both important metrics in the financial industry, but they measure different aspects of investments. While weighted average maturity focuses on the time it takes for a portfolio's securities to mature, weighted average loan age considers the age of loans in a portfolio.

What It Means for Borrowers

Understanding weighted average life and weighted average maturity is not only important for investors and lenders, but also for borrowers. Borrowers can use these metrics to evaluate the terms and conditions of loans and mortgages they are considering. By calculating the weighted average life or maturity, borrowers can assess the duration of their financial commitments and make informed decisions.