What Does Half-Life Mean?
The term half-life refers to the point at which half of the total principal of a debt obligation comes due or has been paid off. The half-life of a debt vehicle is generally determined in the contract between the lender and borrower. It may not necessarily be the exact halfway point of the repayment period as certain variables, such as interest rates and the amortization periods, generally affect the date. The half-life allows borrowers to determine the point at which they have paid half the principal.
- Half-life represents a date in the future when half of the total principal of a debt obligation is paid off.
- The half-life can be determined for any form of debt, including loans, mortgages, bonds, or mortgage-backed securities.
- Interest rates and amortization schedules can affect the half-life of a debt vehicle, especially for mortgages.
- The half-life of a bond depends on repayment through amortization or a sinking fund provision.
- Mortgage prepayments and refinancing can cut down the returns for MBS investors.
There are normally two parts to a debt obligation. These two components are the principal balance and interest. The principal is the total amount borrowed while interest is the cost of borrowing expressed as a percentage rate. At the onset, most of the payments go toward interest. But as time goes on, more of the payments are applied to the principal balance.
The half-life is the point at which half of the principal balance is paid for a form of debt. This includes loans, mortgages, various corporate or municipal issues, and other assets like mortgage-backed securities (MBSs). For instance:
- In real estate, half-life signifies the halfway point of mortgage repayment.
- Bonds that are outside of the mortgage realm have a half-life that is dependent on repayment through amortization or a sinking fund provision.
For an MBS, home loans are sold by issuing banks to financial companies or government-sponsored enterprises (GSEs), such as Fannie Mae, Freddie Mac, and Ginnie Mae. These are then bundled together to form single investable securities. 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 the cost of borrowing falls, the principal will be paid off quicker as homeowners are incentivized to refinance their mortgages at cheaper rates. Conversely, as interest rates rise, the half-life will increase as homeowners take longer to pay off the outstanding mortgage on their property.
In marketing, the term half-life refers to the point at which half of a company's customers respond to its campaigns.
The half-life date of a mortgage should typically occur later than the chronological halfway point of the loan. In certain circumstances, however, this moment can arise much quicker. The average home mortgage term in the U.S. is 30 years, yet the average half-life of an MBS is about 12 years. Why?
This occurs because some mortgages packaged into MBSs are paid off ahead of schedule. Each time a homeowner makes a prepayment, it speeds up the amount of time it takes for these investments to recoup half of the principal on the underlying mortgages.
Getting paid quicker than expected is normally a good thing. That's not the case for MBS holders. When homeowners refinance, investors get paid the principal they are owed but also miss out on interest that was still due on the original mortgage.
This makes the job of predicting where interest rates are heading fundamental to the MBS investor. Steady rates should prolong the duration of an MBS and subsequently the length of the half-life, ensuring more money is recouped from the investment. Rising rates are not so favorable, though, as they often leave investors stuck with lower yields than they could get elsewhere.
Example of Half-Life
As noted above, the term half-life can be applied to any number of debt obligations. Here are two examples of two popular forms—mortgages and bonds.
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 instance, that a person takes out a 30-year mortgage for $100,000 to purchase a home, with a 5% interest rate. This makes his or her 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 for a bond can also vary. For instance, 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, therefore, reach its half-life after 15 years.