The term “weighted-average life of investments” has a very specific meaning under federal law. This calculation is important in the regulation of credit unions. Credit unions are financial entities dedicated to providing reasonable loans to its members. Weighted-average life of an investment is an estimate of how long it takes for the credit union to receive a dollar of principal back from the debtors to which it loaned money. This calculation is used by a credit union to determine what levels of liquidity and investment it needs to maintain to comply with federal standards.
A credit union is a type of financial institution devoted to providing cheaper loans to their members. To qualify as a member of a credit union, the individual must be a part of the community the union is trying to serve. Often, this community is either defined by the town where the person lives or the company where the person works. Members join by purchasing shares or depositing funds, which the union then uses to make its loans. The proceeds of these loans are often paid out to the members as dividends. Credit unions operate under state and federal law.
Passed in 1934, the Federal Credit Union Act was a response to the Great Depression and allowed for the creation of credit unions to help facilitate loans in communities while promoting thrift. Federal credit unions are supervised by the National Credit Union Administration. The NCUA ensures that credit unions maintain proper reserves in case of uncollectible loans, that union funds are only placed in appropriate investments, and that union management follow all relevant bonding and reporting procedures.
Credit unions are required to maintain a certain amount of reserves in case members want to withdraw their cash. To ensure that this reserve is maintained, federal regulations require that certain percentages of the union’s resources be kept in investments that will terminate within a certain amount of time. This is where weighted-average life becomes a factor. Federal regulations require that a percentage of the total amount invested be kept in classes of instruments that have weighted-average lives within certain ranges. So, for example, a credit union can have no more than 6 percent of its investments in instruments with a weighted-average life greater than one year but less than three years. This is done to ensure that the union is not overinvested to such a degree it cannot make its reserve requirements.
Generally, the weighted-average life of an investment is measured by multiplying each amount of principal to be received by the amount of time that will pass from when the loan was issued to when the amount was paid back. Next, all of the principal-time products are added together and the result is divided by the total principal to arrive at the weighted-average life of investment. For example, assume a credit loan issued a $1,000 loan with two payments a year apart with equal principal repayments. The weighted-average life of the investment is calculated by adding $500 (or $500 times 1 year) to $1,000 (or $500 times 2 years) to get $1,500. That amount is divided by $1,000, or the total principal, to arrive at 1.5 years.