What is Average Life?
317 reads · Last updated: December 5, 2024
The average life is the length of time the principal of a debt issue is expected to be outstanding. Average life does not take into account interest payments, but only principal payments made on the loan or security. In loans, mortgages, and bonds, the average life is the average period of time before the debt is repaid through amortization or sinking fund payments.Investors and analysts use the average life calculation to measure the risk associated with amortizing bonds, loans, and mortgage-backed securities. The calculation gives investors an idea of how quickly they can expect returns and provides a useful metric for comparing investment options. In general, most investors will choose to receive their financial returns earlier and will, therefore, choose the investment with the shorter average life.
Definition
Average life refers to the expected duration that the principal of a debt issuance will last. It excludes interest payments and only includes principal payments on loans or securities. In loans, mortgages, and bonds, average life is the average period before the debt is repaid, considering amortization or sinking fund payments.
Origin
The concept of average life originated from the need in financial markets to assess the risk of debt instruments. As financial products became more complex, investors required a method to gauge the timing of their investment returns, leading to the widespread use of average life calculations.
Categories and Features
Average life is primarily used for installment bonds, loans, and mortgage-backed securities. It is characterized by providing a measure of the speed of investment returns. A shorter average life typically means investors can recover their principal faster, while a longer average life indicates a longer investment return period.
Case Studies
Case Study 1: Suppose a company issues an installment bond, and investors use average life calculations to assess its risk and return timing. Case Study 2: In mortgage-backed securities, investors use average life to determine when they can expect the recovery of the principal.
Common Issues
Investors often confuse average life with maturity date. Average life only considers the time for principal recovery, whereas the maturity date is the final repayment date of the entire debt instrument.
