Half-Life: What It Means, How It Works, Example

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. Also known as the average life, the half-life allows borrowers to determine the point at which they have fully paid half the principal.

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 variables, such as interest rates and amortization schedule, affect the timeframe.

Understanding Half-Life

The two parts to a debt obligation commonly include the principal balance and interest. The principal is the total amount borrowed and 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 of the debt is fully paid. This applies to loans, mortgages, various corporate or municipal issued bonds, and other assets like mortgage-backed securities.

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.

In mortgage-backed securities, home loans are sold by issuing banks to financial companies or government-sponsored enterprises, such as Fannie Mae, Freddie Mac, and Ginnie Mae. These are then bundled together to form single investable securities. Half-life occurs when half of the aggregate principal of all underlying mortgages is paid. 

Mortgage-Backed Securities

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 a mortgage-backed security is about 12 years. Why?

This occurs because some mortgages packaged into mortgage-backed securities (MBS) are paid 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.

Mortgages

A mortgage's half-life is the halfway point of principal repayment. Due to amortization and the inclusion of interest, early payments in the loan are weighted to pay more interest than principal.

For a 30-year mortgage loan of $100,000 to purchase a home, with a 5% interest rate, assume a monthly payment of around $500. Early payments included a high level of interest payment with less applied to the principal. In this scenario, the half-life will not be 15 years on a 30-year loan, but more likely closer to 19 years to pay off half the mortgage's principal.

Bonds

The half-life of a bond can also vary. A 25-year bond may include 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 plus the number of years required to retire half the issue. The bond will, therefore, reach its half-life after 15 years.