Indexed universal life insurance policies generally offer two types of policy loans. Though the language can be a bit intimidating to some, by the end of this introduction, you should have a solid understanding of what’s available and how the different loan options work.
Typically, indexed universal life insurance policies have two loan options. The first loan type is the traditional loan (sometimes referred to as the fixed loan option). The second loan type is the indexed loan (sometimes referred to as an “arbitrage” loan).
The biggest identifying characteristic to traditional loans is the adjustment that takes place to the cash values that back the policy loan. Most companies offer these loans with a fixed loan interest rate and adjust the interest rate credited on cash values that back the loan either to a rate slightly below the loan interest rate or peg it to equal the loan interest rate.
This loan option is sometimes called the “fixed” loan option, but that phrase can be misleading since not all traditional loans are fixed. It also implies that indexed loans will always have variable loan interest rates (not true).
Here's an example to help clarify the difference:
Let’s say a policyholder has $100,000 in cash value in his policy and decides to take out a $20,000 policy loan. The traditional loan option has a 3% interest rate and credits 2.5% interest to the cash that backs the loan. The indexed derived interest rate is 11%.
The following will happen to the policy while the loan remains outstanding:
- $80,000 of the cash surrender value and any increases in cash values that do not back loans will continue to earn the index derived interest rate of 11% for an interest increase of $8,800
- The $20,000 loan will accrue $600 in interest annually and the policyholder can choose to pay or simply capitalize it by allowing the loan to grow by $600.
- $20,000 of the cash value (the cash value that backs the loan) will earn $500 in interest and will continue to earn the interest rate of 2.5% as long as the loan remains outstanding
- The total interest received on all cash values is $9,300
This example outlines a negative loan spread–the interest credited to cash values backing the loan is less than the loan interest rate. Not all traditional loans work this way. Some companies credit the same interest rate to cash values that back a loan as they charge in loan interest. This is often referred to as a wash loan
If the example above used a wash loan instead of a negative loan spread, the net difference would be $600 credited to the $20,000 backing the policy loan instead of $500.
Indexed loans (also called arbitrage loans) have a non-direct recognition element to their functionality. This mean the life insurance company charges loan interest on the outstanding loan, but the interest rate credited to cash values that back the loan are unaffected by the outstanding loan and continue to earn whatever the index derived interest rate is.
Another example will help ensure understanding:
Let’s take the example above, but instead we’ll use an indexed loan. In our example, the indexed loan interest rate will be 6%. The following will happen:
- The $20,000 loan will accrue $1,200 in interest annually and the policyholder can choose to pay this interest or simply capitalize it by allowing the loan to grow by $1,200.
- All $100,000 will earn the 11% interest rate.
- Total interest payments received on all cash values is $11,000.
This example, which shows index derived interest higher than the loan interest rate (or a positive spread) is a very favorable aspect of indexed policy loans.
It should be noted that indexed loan can also have negative spreads.
If we took this same example with an indexed derived interest rates of 1% for the year, total interest payments received would be $1,000. If that happened, the loan grows by $200 more than the cash value.
Indexed loans can have both fixed and variable loan interest rates, and whether the rate will be fixed or variable depends on the issuing company (i.e. some use fixed loan rates while others use variable loan rates).
If you have questions about how indexed universal life insurance might work for you, please reach out to us.