The weighted average life (WAL) of a loan portfolio is a measure of the average length of time that each dollar of unpaid principal remains outstanding. It takes into account the timing and amount of all principal repayments to determine the average tenor of the loans in the portfolio.
Calculating the WAL enables lenders and investors to estimate the timing of cash flows from a pool of loans. This helps with pricing loans, modeling expected returns, and managing interest rate risk and liquidity needs.
How Weighted Average Life is Calculated
The weighted average life calculation gives more weight to payments that occur earlier in the loan term. This reflects the time value of money – a dollar paid today is worth more than a dollar paid in the future.
The exact formula is:
WAL = (∑ t*PVt) / (∑ PVt) Where: t = Each future time period PVt = Principal repayments scheduled to be received at each time period t
To demonstrate how it works, here is simple example:
- A $1,000,000 pool consisting of two loans:
- Loan A: $500,000 outstanding, 3 year term with equal principal payments of $166,667 each year
- Loan B: $500,000 outstanding, 5 year term with equal principal payments of $100,000 each year
- What is the WAL of this pool?
Loan A Cash Flows:
Year 1: $166,667
Year 2: $166,667
Year 3: $166,666
Loan B Cash Flows:
Year 1: $100,000
Year 2: $100,000
Year 3: $100,000
Year 4: $100,000
Year 5: $100,000
∑ t*PVt = (1 * $266,667) + (2 * $266,667) + (3 * $266,666) + (1 * $100,000) + (2 * $100,000) + (3 * $100,000) + (4 * $100,000) + (5 * $100,000) = $800,001
∑ PVt = ($166,667 + $166,667 + $166,666) + ($100,000 + $100,000 + $100,000 + $100,000 + $100,000) = $1,000,000
WAL = ($800,001 / $1,000,000) = 2.4 years
In this case, the 3-year Loan A with faster repayments receives more weight than the 5-year Loan B. So the WAL is closer to 3 years than 5 years.
Using WAL for Different Portfolio Profiles
The WAL metric provides valuable insights that vary for different types of loan portfolios:
Amortizing Consumer Loans
A portfolio of amortizing installment loans like mortgages, auto loans and personal loans will generally have a WAL shorter than the stated term. This is because the amortizing structure pays off more principal earlier in the loan.
For example, a portfolio of 30-year mortgages may have a WAL of just 7 years because most borrowers refinance or move before reaching full maturity. This informs interest rate risk strategies and pricing decisions.
Revolving Credit Lines
For revolving portfolios like credit cards or HELOCs, the concept of WAL is replaced with Weighted Average Life to Maturity (WALM). This assumes credit lines are paid down at maturity rather than during the revolving period.
In reality, credit line usage fluctuates, so WALM serves more as a stress test of liquidity under worst-case redemption behavior. The actual timing of cash flows varies significantly.
Bullet Repayment Structures
Portfolios with bullet maturities like bonds, commercial loans or interest-only mortgages have a WAL equivalent to the stated term. With repayment concentrated at maturity, there is no acceleration of principal payments over time.
The lengthy WAL highlights heightened interest rate and extension risk in bullet structures. Investors rely primarily on secondary market liquidity rather than amortization.
Modified Loans
For troubled loans modified to reduce payments, the WAL will extend beyond original maturity. Lenders delay principal paydowns with concessions like rate reductions, term extensions and principal forgiveness.
The portfolio WAL reveals reliance on modified loan performance. As re-defaults rise, the WAL may shorten again as liquidations accelerate.
Conclusion
The weighted average life calculation provides a valuable window into the expected timing of principal cash flows from loan portfolios. It enables investors and lenders to better model returns, risk exposures, and liquidity needs.
While simple in form, interpreting the WAL result requires understanding the repayment characteristics across various asset classes. Assumptions on voluntary prepayment speeds versus defaults drive variability.