Average Life

Understanding Average Life: Definition, Calculation, and Risks

What is average life?

Average life (also called weighted average life or weighted average maturity) measures the average time it takes for the principal of a debt issue to be repaid. It focuses solely on principal repayments, not interest. Average life is especially useful for amortizing securities—those that return principal in installments—because it shows when investors can expect to receive their principal back and helps assess timing-related risk.

Key takeaways

• Average life reflects the timing of principal repayments, not interest.
• It helps investors compare and select amortizing bonds, loans, and mortgage- or asset-backed securities.
• Shorter average life generally means quicker return of principal but may signal higher prepayment risk.
• Mortgage-backed and asset-backed securities are particularly sensitive to borrowers’ repayment behavior and default risk.
• Prepayment risk can shorten average life and reduce expected interest income.

How average life differs from maturity

Maturity is the final date when the remaining principal is due. Average life is the weighted average timing of all principal payments over the life of the security. For amortizing instruments, average life is typically shorter than maturity because principal is repaid before the final maturity date.

How to calculate average life

1. List all scheduled principal payment amounts and their payment dates.
2. Convert each payment date into fractional years from the valuation date.
3. Multiply each payment amount by the time (in years) until that payment.
4. Sum those weighted values.
5. Divide the sum by the total principal (face value).

Formula: Average life = (Σ(payment amount × time until payment)) ÷ total principal

Example:
A 4-year bond with face value $200 makes principal payments of:
* Year 1: $80
* Year 2: $60
* Year 3: $40
* Year 4: $20

Weighted sum = ($80×1) + ($60×2) + ($40×3) + ($20×4) = 400
Average life = 400 ÷ 200 = 2 years

Although the bond matures in 4 years, its average life is 2 years because principal is repaid progressively.

Average life in mortgage-backed and asset-backed securities

For MBS and ABS, average life represents the expected time for borrowers to repay the underlying loans. Payments to investors depend on borrowers’ principal and interest payments and on prepayments or defaults. Because borrower behavior influences cash flows, average life for these securities is more uncertain and typically modeled under various prepayment and default scenarios.

Key risks affecting average life

• Prepayment risk: Borrowers or issuers repay principal earlier than expected (e.g., refinancing mortgages). This shortens average life and reduces future interest income for investors.
• Default risk: Borrowers fail to make payments, which can extend or effectively eliminate expected principal recoveries and lead to losses.
• Model and scenario risk: Estimates of average life depend on assumptions about prepayment and default behavior; incorrect assumptions can produce misleading estimates.

Some securities include prepayment penalties or triggers to mitigate prepayment risk.

Practical considerations for investors

• Use average life to compare the timing of principal return across amortizing investments.
• Consider scenario analysis (fast, slow, and base-case prepayment/default assumptions) for MBS/ABS.
• Align average life expectations with cash flow needs and interest-rate outlooks—shorter average life reduces exposure to rising rates but can lower expected interest income if prepayments accelerate.
• Examine contract features (prepayment penalties, call provisions) that affect actual average life.

Conclusion

Average life is a key metric for understanding when principal is likely to be repaid on amortizing debt. It complements maturity by revealing the timing distribution of principal repayments and helps investors evaluate timing risk, prepayment exposure, and suitability of an investment for their cash-flow and risk preferences.