What is a Half-Life
Half-life is a term for the future date when half of the total principal of a mortgage-backed security (MBS) will be paid off. It can also represent the date when half of a person's private mortgage principal is paid off. While an estimate can be made as to what the half-life will be, it is not definite as the variables of the security or mortgage may change.
BREAKING DOWN Half-Life
Half-life, when it comes to real estate investment vehicles, is the half-way point of a mortgage repayment. For an MBS, this means that the half-life occurs when half of the aggregate principal of underlying mortgages is paid. The time taken to reach half-life is dependent upon interest rates. As interest rates fall, the principal will be paid off quicker as homeowners refinance their mortgages. Similarly, as interest rates increase, the half-life will increase as homeowners take longer to pay off their principal.
Half-life can also be used to represent the halfway point of repayment for other forms of bonds or debt. Bonds that are outside of the mortgage realm will have a half-life that is dependent on repayment through amortization or a sinking fund provision. For example, 25-year bonds sometimes have a provision where 5% of the bond's principal has to be repaid after five years of the issue. In this case, the bond has a half-life of five years, added onto the number of years required to retire half the issue. The bond will then reach its half-life after 15 years.
Example of a Single Mortgage's Half-Life
A mortgage's half-life is the halfway point of principal repayment and doesn't include interest payment. However, the higher the interest, the longer it will take to reach the principal's halfway point. Let's say, for example, that a person takes out a 30-year mortgage for $100,000 to purchase a home, with a 5% interest. This makes his monthly payment around $500, which starts with a high amount of interest and declines over time as more principal is paid. In this scenario, it will take more than 19 years to pay off half the mortgage's principal, due to the effects of interest.
The Half-Life of an MBS
Like the example above, an MBS reaches its half-life after the combined principal of the underlying mortgages are paid off. Some of the mortgages are paid off quicker than others, and the average half-life of an MBS is about 12 years. However, there are extension risks associated with all MBS securities. The reason the expected half-life is normally 12 years is that some of the underlying mortgages conduct prepayments to shorten the length of the mortgage. When interest rates rise, prepayments decline and the length of the half-life increases.