What Does Half-Life Mean?
Half-life is a term used to describe a future date when half of the total principal of a mortgage-backed security (MBS), or another form of debt or bond, will be 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.
- Half-life represents a future date when half of the total principal of a mortgage-backed security (MBS), or another form of debt or bond, will be paid off.
- In real estate, the higher the interest, the longer it will take the homeowner to reach the halfway point of mortgage repayment.
- For bonds outside of the mortgage realm, a half-life is dependent on repayment through amortization or a sinking fund provision.
In real estate, half-life signifies the halfway point of a mortgage repayment. For an MBS, home loans are sold by the issuing banks to a government-sponsored enterprise (GSE) or a financial company and then bundled together to form a single investable security; this means that 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.
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, therefore, reach its half-life after 15 years.
Example of 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 instance, that a person takes out a 30-year mortgage for $100,000 to purchase a home, with a 5% interest. 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 of an MBS
As the example above shows, 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.
In the United States, the average mortgage term is 30 years, yet the average half-life of an MBS is about 12 years. Why? Because some of the mortgages packaged into these investments 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.
Normally, getting paid quicker than expected is 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 the rest of the 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.