What About My Good Credit?

Every once in a little while this question comes up and recently I had someone ask me about this and decided it was a good topic to address.  We know that when a policy loan is taken, there is interest charged on that loan that is collected by the insurance company.  Now, since whole life insurance is issued by and large by Mutual Insurance Companies the fact that a policy holder is paying interest to a company he or she owns a part of, and participates in the divisible surplus (read profits) of the company, it’s not really a kiss-it-goodbye scenario.  Still, though, some people take literal phraseology very seriously (I’ve been in two…disagreements we’ll call them…over it literal definitions this week alone).  So, for those who look at interest charged on a policy loan and say, “I can get better financing than that with my good credit” is this necessarily the moment when we infinite banking hawks sit back down and say it works for everyone except you Mr. and Mrs. 850 FICO?

Nope (honestly do you think I’d be so happy to talk about it if it was?), the truth is American capital markets vis-à-vis your personal credit score is a market place ripe for unscrupulous smoke and mirrors used to suck every dollar on the table away from those who are good at paying their bills on time but suck at math (in truth if you knew what went into establishing an excellent credit score you’d have to be pretty bad at math to play the game, but more on that later).

Lets take the following example to show how a little juxtaposition and slight of hand can benefit the merchant and the bank, and leave you on the…uhh…”back” end of the deal.

You want to buy a brand new car for 25,000 and you’re presented with the following two options regarding financial incentives:

  1. 3,000 cash back and a 36 month loan at 4% APR
  2. 0% financing for 36 months.

A lot of people opt for the 0% financing because they don’t have to pay any interest.  Really?

Nelson Nash’s operation ingeniously pointed out some time ago that we finance every purchase we make.  It’s just a matter of paying interest to someone, or giving up interest we would have otherwise made on money we had (or could have had).

So let’s do some math…don’t worry nothing you shouldn’t have learned in high school:

The 0% interest one is easy, it’s  25,000 divided by 36 which comes out to approximately $694.44 as a monthly payment.

It’s calculating the monthly payment on the amortized loan with interest that causes a lot of problems.  It’s simply the solve for payment in a Time Value of Money equation given 36 periods, a $22,000 present value, a .333% interest rate per period (4% divided by 12 since we are calculating the monthly payment) and a future value set to zero (we want the loan to be paid off with the 36th payment).  The payment comes out to  approximately $649.49 (anyone who works with TVM calcs knows we always quote these as approximations because there’s a lot of rounding that goes on but that variation is usually little more than $5 one way or the other).

You should be immediately able to recognize something that a lot of people find shocking.  The incentive that offers cash back and still charges you interest leaves more money in your pocket.  About $1618.64 after those 3 years are over.  That’s roughly $539 per year.

Long ago someone (can’t remember who sorry) coined the phrase “Interest, those who understand it collect it and those who don’t pay it.”  Believe it or not, some people still wish to pick a fight about the above example because they don’t want to pay the bank any interest.  If the money stayed in your pocket and you saved it over the course of 40 years (extrapolating our example occurring every year over the course of 40 years) your $539 per year ends up being $65,111.  You’re paying the bank plenty of interest when you opt for the 0% financing option in the fashion of supplying them with capital they can use to make money, which you now cannot use.

What if Not all goes According to Plan?

The above example is a good scenario, where things work out the way they are supposed to.  How do these examples work if life gets in the way of your grand plans?  Well, if you get laid off, fired, or get diagnosed with Cancer that required chemotherapy that prevents you from going to work and collecting a pay check you might have a hard time making the loan payment.  And your pretty much screwed either way.  At the Salus Agency, we talk a lot about safety and security.  What if you could secure a loan that didn’t effect your ability to continue to increase your wealth, and if you couldn’t pay, it didn’t mean default?

If you don’t send a check into your the insurance company to make a loan payment, you know what happens to your credit score?  Nothing.  Now, it’s fair to say that paying off your policy loan won’t impact your credit score at all either (there, don’t send me emails pointing that out, please).  But then again, having a policy loan outstanding isn’t going to effect your debt to income ratio either (I have a recent prospect who was looking for a mortgage to move into a new home and the bank won’t talk to him because he co-signed on a few student loan for his daughter and his debt to income ratio is looking kind of crappy these days).

What if your once good credit score takes a tumble?  It happens, things go badly.  The average  credit score in the United States has dropped since the breakout of the economic crisis.  And despite layoffs and job disappearances 50% of personal bankruptcies and 50% of all mortgage foreclosures–something that obliterate your good credit–are still the result of an illness or injury that took someone out of work (something that could happen in either a good or bad economy).

What happens if you don’t pay your bills on loans you’ve signed with banks?  The collections departments give you a call once or twice a day (or once every hour on the hour every day).  What happens if you don’t make payments on your policy loan?  You screw yourself in essence (just like you screw the bank when you don’t pay back a loan with them).  But at least there aren’t any debt collectors on the phone or ruined credit scores out of the deal.

People with Good Credit Scores are: Smart/Worried about Keeping Banks Happy (circle one)?

We’ve probably all heard the classic dogma championed by the lending industry that a good credit score will save you thousands, but does it really?  What does it actually take to have a good credit score?  We collected a bunch of advice on the best tips for increasing your credit score and came up with the top 5 most frequent suggestions:

  1. Pay your bills on-time: Seems easy enough, and for the most part this one is a no brainer, and it’s not surprising that it was the number one suggestion everywhere we looked.  This one doesn’t involve and complex planning, and should be straightforward for everyone.  However, it does sit on somewhat perilous ground considering the safety notion mentioned above.  Still, this one is pretty easy.
  2. Keep your balances low: this one makes sense for those who understand credit risk vis-à-vis debt utilization (most of you have probably heard of a debt utilization ratio).  But, there’s sort of a laughable issue with this one.  The best way to maximize your credit score is to keep your available credit unused.  Makes sense, but it also calls into question what happens every time I take out a loan for something. Or what about consolidations?  Oh wait, they spoke to that as well
  3. Avoid consolidations: WTF?  Yeah this one left us scratching out heads just a little bit.  Apparently consolidating loans loads up one source of credit and maxes it out in most cases (especially when people take advantage of a 0% introductory offer on a new credit card).  So, whenever you save yourself real money and consolidate your debt, the lending industry seeks revenge on you by lowering your credit score.  Weird.
  4. Keep your history for as long as possible: this means leave accounts open if at all possible (this applied mostly to revolving credit accounts–aka credit cards–as an amortized loan is closed once the principle amount has been repaid.  It’s a fairly typical piece of advice that is tied to the debt utilization ratio, but more is more focused on an established history.  Lenders like to be able to look back as far as possible to see if you have skeletons in your closet.  However, most lenders have just as much authority over the status of your credit account as you do.  They can (and have) use this option pretty much as they see fit.  So, if you have an old account that hasn’t been used in a while, you might want to go buy this weeks groceries with it, to ensure it sticks around for another year or six months.
  5. Only apply for credit when necessary (i.e. avoid “hard inquiries” on your credit history: credit reporting agency record every time someone looks up your credit report.  Some of these are harmless queries like self checks performed by you, employer checks (why would your credit score matter to them anyway?), and promotional offer checks (like when Capital One take a quick peek to see if they want to “pre-approve” you for a credit card offer.  So-called “hard inquiries” are those that are initiated by you for consideration for a new loan.  These include a bank pulling up your credit report to decide if they want to approve you for a loan, a dealership running your credit report to see if they can get you approved for a loan, and any time you apply for a credit card (including any time you are at our favorite store and they ask you if you want to save X% off by opening up a <insert name of store> charge card).  These inquiries are a little ding against your credit score.  The reason for it is some what counter intuitive.  According to the lending industry, it’s because you are potentially opening a new line of credit (read: taking on more debt) which could be a bad thing.  However, if approved, it could also decrease your overall debt utilization ratio (yeah, credit scoring makes that much sense).

There was one other frequent suggestion that we decided to keep off the list because it was a tad spread.  The suggestion was to keep a constant eye on your credit score.  Some would make a blanket statement like that.  Others would further suggest you do this by enrolling in (read: paying for) credit monitoring services (hey, it’s Suze Orman approved!).  So you save money, you have to spend money.

But we bring all this up for one simply reason.  The original point that was made at the top of this post.  That credit is more about keeping the focus on the wrong thing (just like a magic, and magic makes us all feel a little happy inside, right?).  The lending industry has mastered the art putting the focus on the wrong area to make money.  People with high credit scores are more sycophants to the lending industry, than they are monetary geniuses who have successfully managed their money.  To be a little more blunt, employers check credit scores because they are sitting on data about trends among Americans concerning those with high credit scores and those with low credit scores.  What does that data suggest?  That those with higher credit scores hold onto an extremely higher sense of importance for respecting authority than those with lower scores (like we suggested above, they ain’t doing it because they plan on your asking to borrow money at some point in the future).

Now, lets be clear about something here, this is not a call to say “screw it” to your next credit card bill all in the name of being an individual.  There’s a very real role having a decent credit score plays in one’s life.  The point is, don’t fall for the hype, and don’t lose focus on the important things. Don’t stare at your feet, lift your head and look at the bigger picture.  Let’s go back to our car buying situation and address option 3, the be your own banker approach.

So you take out a $25,000 policy loan and buy the car.  Repaying the loan $8,000/year.  Assuming a 5.25% interest rate on policy loans at the end of 3 years you’d have about $2400 remaining on the loan.  Once that’s paid you’d you’ll have paid $26,400 back.  And now the people who are quick at arithmetic but bad at understanding the concept are going to go ballistic.  $26,400 means this is the most expensive option, right?  WRONG!

Remember, the $25,000 that you pledged as collateral for the loan didn’t go anywhere.  It stayed put and continued to earn dividends.  Say, 6% per year.  This means you’re now 4 years down the road.  You have no loan outstanding on the car.  And you have approximately $31,500 in cash surrender value in your policy.  And what would have happened if you never took the loan out?  You’d still have $31,500 in CSV.

But wait.  What about that other offer that gave you cash back if you financed the purchase through the bank at the dealership.  Didn’t you save something like $3,000 if you took that deal?  Making the total purchase amount $22,000?  So what if we signed up for that deal, and then used a policy loan immediately after to pay that loan off?  We’d keep our balances low and we’d more than pay our bills on-time.  We then only need a $22,000 policy loan, which brings the total amount we’d pay back down to $23,088 (now it’s the lowest out of pocket option) and the CSV after 4 years?  Still $31,500.  And if we repeated this every year for 40 years what do we end up with?  About $257,000.


3 Responses to “What About My Good Credit?”

  1. Hari says:

    Hi,
    It is mentioned
    “The 0% interest one is easy, it’s 25,000 divided by 36 which comes out to approximately $394.44 as a monthly payment.”

    The amount should have been $694.44, right?

    “We then only need a $23,000 policy loan, which brings the total amount we’d pay back down to $23,088 (now it’s the lowest out of pocket option) and the CSV after 4 years? ”

    if loan is take from policy for $23,000, after 3 years we need to pay $25,456.17, right (i.e. with 5.25% mentioned above).

    Also will the dividend rate for NDR policy be greater than the loan rate on policy. That would be a loss for insurance company, right?

    • Brandon Roberts says:

      Hi Hari,

      Yes it should have read $694.44, thanks for catching that.

      As for the total repayment amount. Not exactly. I used a company’s illustration software and plugged in the numbers until the loan was gone, this is the amount I needed to pay back in order to retire the loan. If we were assuming an annual 5.25% for all 3 years we’d have a monthly payment of $658.95 or $23,722. But, the loan rate from the insurance company wasn’t 5.25%. We used that slightly higher rate as a buffer, which is a good practice.

      Regarding the loan and dividend spread not necessarily. Policy loan income is not the only source of income for the insurance company and the comparison of dividend rate to policy loan interest rate isn’t a complete picture of what is going on. So a higher dividend rate than policy loan rate would not necessarily translate to a loss for the insurance company.

  2. Hari says:

    Thanks for the clarification.

    If there any advantage in paying off the vehicle loan with policy loan?
    In any case we have to pay interest to either car financier or to the insurer. So do we really have any advantage of paying off loan with policy loan (other than improving credit history)?

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