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Life Insurance Loans Explained
Today we’re going to talk about borrowing – specifically borrowing against a life insurance policy that you designed to be your own private family bank.
And what you see me show up on the screen here are the different parties involved – up in the top left would be a traditional bank, over in the right would be an insurance company, down on the right would be your insurance policy designed for banking, and obviously on the left is your family for which whom you’re funding the bank for.
The biggest advantage to borrowing against a policy is the fact that, however much you borrow, your full equity is compounding for you regardless of how much you borrow. People often mistake this as “Aren’t I borrowing my own money? And when I pay interest aren’t I paying interest back to myself?”
Although it may feel like that and the impact of the policy almost makes it seem like that’s what happens. But technically you’re not.
What’s actually happening is the insurance company is happy to give you a loan at any time for any reason. In fact, they’re going to put it in the contract language of the policy that they’re guaranteed to provide you liquidity up to the sum function of your cash value. Usually, it’s somewhere between 80 to 90 percent and they’re happy to do this because essentially they’re just holding your policy as collateral.
They’re the one that has your cash value, so if you default you don’t need to worry about paying them back. You just lose your policy and your policy equity. So going back to the collateral, even though they’re holding this value as collateral and if you look at your statement the net surrender value (NSV) will be lower. If you had one hundred thousand dollars of cash value and let’s just say you borrowed 80 it might show up like you only have twenty thousand of net surrender value but actually, the full balance would still compound for you, including the amount you borrowed. And that’s because it never left the policy.
Again the life insurance company is just earmarking it as collateral while you make the loan. So they’re going to provide you with the liquidity and for that liquidity, you’re responsible for paying them interest. You don’t necessarily have to pay interest on a schedule like you would with a traditional loan, but we’re going to talk about that in just a little bit.
So once you get the liquidity it’s going to come in the form of a check. While some people discussing banking are saying “Hey, get away from the banks”, you still have to deposit this somewhere to actually get the money to go use, be it for vehicles, investing in real estate, investing in your business, or some kind of family expense.
The thought of completely cutting banks out of the picture may be a little asinine and really you should use banks for what they’re good for. And that’s convenience and their technology.
The fact that they have branches, online transfers and bill pay, and what not. Banks are totally fine to use for the convenience of moving your money.
But as far as parking your reserves, we suggest when you’re talking about big dollars to use a policy since not only are you going to most likely get more growth but there are additional benefits too, whether it be a death benefit or other kinds of chronic illness, critical illness, chronic critical injury benefits, terminal illness… There are other benefits you can get from the policy, not to mention whatever growth you do get would be sheltered from taxes so long as you keep some sort of this policy in force.
Again, although it may seem like you’re paying yourself interest, you’re not. You’re paying the insurance company interest for the use of their funds but they’re not they’re not taking away any of your funds from growing inside their coffers at oftentimes more generous rates than you’d find in an actual bank.
A common question I hear is this: “Is a 401k loan kind of like borrowing against your life insurance policy?” You’ve already learned that one of the key differences with life insurance is that you’re borrowing against an asset that continues to compound for you.
With the 401k loan, it’s actually just the opposite. You’re actually borrowing from your 401k. Let’s just say you took a loan out from your 401k, the rest of your account would continue to stay in the funds that you had and hopefully grow for you. But they’re actually going to redeem the funds, they’re actually going to extract the money from your funds, give it to you and that’s why I say it’s a single-use dollar.
The money that you pull from a 401k is working for you whatever you’re doing with those funds. With life insurance, it could be working for you in multiple different ways. Well, it’s working for you inside the policy even though you have a lien against some of your cash value. It’s also being used for whatever you’re investing in, be it real estate or whatever, but also there are these additional benefits.
There is usually a substantial death benefit (over and above your cash value) which can go to provide liquidity your family if you were to pass away prematurely, even if you have a loan outstanding. The insurance company would just lop off the amount of the loan from the death benefit they ultimately pay out but also some of these policies now have chronic illness benefits, critical injury benefits, terminal illness so that they are propping up additional benefits and that’s why I say not only is that dual purpose money but it’s multiple use money. It’s like you have one dollar wearing multiple hats for you with a policy.
So going back to some of these other parameters of the loan to value percentage which is what I have listed first here, is a very big differentiator. With the 401k loan, the maximum you can borrow is 50 percent of your account value and that’s only up to fifty thousand dollars. When you get up to a greater than one hundred thousand dollar account, you can still only borrow the 50. As your account value grows, this percentage will get become less and less.
With a life insurance policy, it really depends on a lot of factors but we find oftentimes it’ll be somewhere between 70 to call it 90 percent of your account value. Sometimes it’ll be a little bit more, sometimes to be a little bit less. This depends on how much you’re funding over and above the basic premium, whether or not you have any kind of high cash value riders on the policy, whether or not there are any surrender charges, but it’s usually substantially higher than what you can borrow from a 401k.
Both of these are a private loan from the standpoint of it not being on anybody’s credit checks or any radars – the fact you have a 401k loan. However, I was reflecting when I put this on here that to some degree a 401k loan is like a public loan in that you still owe tax. You do owe tax on some of this balance.
Essentially, you’re borrowing from public funds, which is probably why the parameters and loan terms you’re going to see below aren’t nearly as favorable. And there are no additional benefits that I know of from borrowing from a 401k.
If we continue, the payment structure of a 401k is quite rigid. You usually have to pay it off within 5 years or sooner, and it may be sooner if you leave your job. If you left your place of employment, you have about 60 days (maybe 90 days) to pay off this 401k loan. And if you don’t, it’s deemed a premature distribution. And so the consequences would be you owe taxes on that money and penalties – the 10 percent premature withdrawal penalty if you’re under age fifty-nine and a half.
With a life insurance loan, conversely, there are very flexible payment terms as we’re going to see below and the consequences for default are really that you just lose your policy. And I know that that seems quite dire. But what’s ironic about this is when I talked to people about using life insurance to build their own bank they often tell me that they don’t really care about the death benefit. They just want maximum performance. It’s all about the cash.
But yet, somehow when I say “Hey you’re losing your life insurance policy”, the thing they didn’t care about… they’re like “Really? I don’t want to lose that…” Which I find a little bit amusing.
You’ve probably seen other videos where I talk about how paying cash is almost like a dead asset though. You’re saving up cash and spending cash and saving up cash and spending cash. When we compare that with saving in life insurance, letting it compound, and then doing the same cash flows and borrowing against the policy to hopefully end up at a higher place in line. Each and every time, even if you cashed out the policy very early on you’d be at roughly the same position if you just paid cash. And if you continue doing this for a number of years you’d probably be better off than if you just paid cash the whole time.
But at any rate, let’s go on to the duration.
We did discuss for a 401k loan, it’s a maximum of five years for a life insurance loan. I’m just going to put lifetime meaning the insureds lifetime because technically a lot of people don’t realize this. Technically the loan is not against the cash value. When you borrow against your life insurance policy, although the insurance company is holding your cash value as collateral, the loan is technically against the death benefit. And that actually provides us with some of the most flexible terms that we’re going to talk about here.
When we look at your repayment options with the 401k loan, you have one option. You have to pay very structured principal and interest payments. With a life insurance loan, you could and you should pay principal and interest because what that’s going to create for you is a situation where you’re paying simple interest on a decreasing balance, while earning compound interest on an increasing balance (in a tax-sheltered environment, no less).
You want to at least do that. If you can’t pay principal and interest for whatever reason, we often recommend and even help our clients schedule paying interest only, because when they pay interest only they flatten the liability.
When you flatten the liability and pay interest only, it works almost like simple interest. Whatever loan interest you have to pay, as long as your paying that in a timely manner, it’s not going to compound against you.
Case in point – let’s just say that this is a ten thousand dollar loan at a six percent interest rate. A lot of people don’t realize this, but what most carriers do is as soon as you borrow, they’re going to tack on that interest right here. So in the ten thousand dollars, they’re going to tack on six hundred dollars and just call it your total loan balance.
Now what’s nice is if you do pay down loan interest or you do pay down principal, then what they’re going to do is they’re going to credit you back some of that interest you paid, depending on exactly when you paid it to your policy. When you pay principal and interest or you pay interest only, this can work like simple interest. And again it’s a recipe for success when you’re only paying simple interest on a flat or decreasing balance but you’re earning compound interest on an increasing balance.
Now some people for whatever reason won’t be able to even service interest only. If you can’t, we do recommend that when you can that you pay these unscheduled payments during your lifetime.
So let’s just say you were investing in rental property and you had to make improvements. You just couldn’t afford to pay anything. Once those improvements were done and rents start coming back to you, then as you get some cash and you build up some comfort, we recommend starting to pay down that loan even if you’re just doing it kind of one-off and manually.
Now even if you can’t, like let’s just say you have a major project, you have some serious cash flow constraints again it’s a life insurance loan against the death benefit. Technically as long as the compounding in your cash value is growing by more than liability against you, you’ll have a policy in force and the death benefit will pay it off. It’s nice when you have performance or at least if you continue to pay premiums in the policy, then this line will almost certainly beat this line.
And we’ve run illustrations like that where it actually works out to be quite favorable for people when they do this. Again with the 401k loan, you’ve got one option – structured principal and interest payments.
Hopefully this helps to dispel some of the myths about life insurance policy loans.
Why would I want to borrow my own money? Why would I want to do that when I pay myself back?
And hopefully, you can see that there are some clear advantages to utilizing life insurance as your own bank and that life insurance loans aren’t exactly like traditional consumer debt. And if you treat them responsibly, you can actually produce a better result for yourself and your family in the long run.
John “Hutch” Hutchinson
ChFC®, CLU®, EA, AEP®, CExPs®