What Is an Automatic Bill Payment?

An automatic bill payment is a money transfer scheduled on a predetermined date to pay a recurring bill. Automatic bill payments are routine payments made from a banking, brokerage, or mutual fund account to vendors.

Automatic payments are usually set up with the company receiving the payment, though it’s also possible to schedule automatic payments through a checking account’s online bill pay service. Automatic bill payments occur over an electronic payment system, such as the Automated Clearing House (ACH).

How an Automatic Bill Payment Works

Automatic bill payments can be scheduled for all types of payment transactions. This can include installment loans, auto loans, mortgage loans, credit card bills, electric bills, cable bills, and more. These payments can be automated quite easily from a checking account.

Setting up automatic bill payment involves making arrangements with the bank holding the checking account to make the exact payment each month. The set of instructions is typically created online by the account holder. More frequently, this power is given to the vendor (the utility company, for example) to charge the checking account for whatever amount is owed that particular month. In both cases, the individual paying the bill must initiate the automatic bill payment and provide the necessary information required to make automated recurring payments.

Example of an Automatic Bill Payment

Automatic payments save consumers the hassle of having to remember to make a payment month after month. They can also help consumers avoid late payments.

For example, suppose you have a $300 car payment due on the 10th of every month for the next 60 months. Instead of logging into your online account with the auto loan company to schedule the same payment each month, you could set up automatic payments one time and agree to have $300 automatically transferred from your checking account to the auto loan company on the fifth day of each month. This way, you know your payment will never be late, and you’ll avoid the trouble of doing the same task each month. You’ll also improve—or maintain—a good credit score.

Disadvantages of Automatic Bill Payments

Automatic payments have a couple of potential downsides. If you forget about your scheduled automatic payments and do not maintain a cushion in your checking account, an automatic payment could bounce. Not only will your bill remain unpaid but you might also incur a returned payment fee from the company you were trying to pay, as well as a late fee for missing the due date. And automatic payments aren’t infallible. You still need to check regularly to make sure your scheduled payments have gone through as expected.

Another problem can occur when you authorize automatic payments that vary in amount. For example, suppose you set up automatic payments of your credit card bill from your checking account. If you don’t look at your credit card bill when it arrives, you might have an ugly surprise when it’s automatically paid in a much higher amount than you expected because of a mistake or fraud—or because you simply didn’t realize how much you had spent.

Automatic payments can also be difficult to cancel. Additionally, consumers might forget about certain automatic payments and continue to pay for services that they no longer want.

What Is Average Life?

The average life is the length of time the principal of a debt issue is expected to be outstanding. Average life does not take into account interest payments, but only principal payments made on the loan or security. In loans, mortgages, and bonds, the average life is the average period of time before the debt is repaid through amortization or sinking fund payments.

Investors and analysts use the average life calculation to measure the risk associated with amortizing bonds, loans, and mortgage-backed securities. The calculation gives investors an idea of how quickly they can expect returns and provides a useful metric for comparing investment options. In general, most investors will choose to receive their financial returns earlier and will, therefore, choose the investment with the shorter average life.

Understanding Average Life

Also called the weighted average maturity and weighted average life, the average life is calculated to determine how long it will take to pay the outstanding principal of a debt issue, such as a Treasury Bill (T-Bill) or bond. While some bonds repay the principal in a lump sum at maturity, others repay the principal in installments over the term of the bond. In cases where the bond’s principal is amortized, the average life allows investors to determine how quickly the principal will be repaid.

The payments received are based on the repayment schedule of the loans backing the particular security, such as with mortgage-backed securities (MBS) and asset-backed securities (ABS). As borrowers make payments on the associated debt obligations, investors are issued payments reflecting a portion of these cumulative interest and principal payments.

Calculating the Average Life on a Bond

To calculate the average life, multiply the date of each payment (expressed as a fraction of years or months) by the percentage of total principal that has been paid by that date, add the results, and divide by the total issue size.

For example, assume an annual-paying four-year bond has a face value of $200 and principal payments of $80 during the first year, $60 for the second year, $40 during the third year, and $20 for the fourth (and final) year. The average life for this bond would be calculated with the following formula:

($80 x 1) + ($60 x 2) + ($40 x 3) + ($20 x 4) = 400

Then divide the weighted total by the bond face value to get the average life. In this example, the average life equals 2 years (400 divided by 200 = 2).

This bond would have an average life of two years against its maturity of four years.

Mortgage-Backed and Asset-Backed Securities

In the case of an MBS or ABS, the average life represents the average length of time required for the associated borrowers to repay the loan debt. An investment in an MBS or ABS involves purchasing a small portion of the associated debt that is packaged within the security.

The risk associated with an MBS or ABS centers on whether the borrower associated with the loan will default. If the borrower fails to make a payment, the investors associated with the security will experience losses. In the financial crisis of 2008, a large number of defaults on home loans, particularly in the subprime market, led to significant losses in the MBS arena.

Special Considerations

While certainly not as dire as default risk, another risk bond investors face is prepayment risk. This occurs when the bond issuer (or the borrower in the case of mortgage-backed securities) pays back the principal earlier than scheduled. These prepayments will reduce the average life of the investment. Because the principal is paid back early, the investor will not receive future interest payments on that part of the principal.

This interest reduction can represent an unexpected challenge for investors of fixed-income securities dependent on a reliable stream of income. For this reason, some bonds with payment risk include prepayment penalties.