Whole Life Insurance Loans are a Scam

whole life insurance loansThe other day I happened upon a piece that MSN Money reposted telling me (and you) what I (we) needed to know about whole life insurance. The piece is horrendously bad, but if you really want to read it, you can find it here—just don’t take anything it says seriously or as fact.

You’ll notice that the article really doesn’t say anything about whole life insurance loans and the truth is my beef isn’t with the article. Well, at least not for today. Maybe sometime in the future we’ll go back and count the errors Neda Jafarzadeh made. It’s truly sad that US News would green light such an erroneous piece of “information.” But we have other things to discuss.

I don’t typically spend much time on the comment section of news articles. Though I freely admit they tend to be the most entertaining section of the most news articles. Luckily one comment caught my eye as I quickly scrolled down the page about ready to close the tab. A comment from one AgainstGovernmentWaste who noted:

“Whole life insurance is the pay day lender of the middle class.” ~ Dave Ramsey

Oh boy!

Okay, Made You Look

Yeah so if you happened upon here looking for a self-serving piece on why whole life insurance et. al. sucks you might want to move on. Or you can stick around and learn something, up to you.

And of course our good friend Dave finds his way front-and-center on yet one more post on the Insurance Pro Blog. And I have to admit, of all the asinine things I’ve heard come out of his mouth, this was not one of them. Though it didn’t really surprise me that this quote was attributed to him. And based on some Google fact checking, I believe the above quoted statement may be a tad paraphrased, but that’s okay. What’s important is that Dave made comments suggesting the very sentiment.

This got me thinking…

One of the many evils of whole life insurance (again if your new welcome, and italics are often a sign of sarcasm around here) is the fact that your money isn’t your money. Instead those pricks at the insurance company make you take a loan and charge you interest on it if you want it.

To some degree (big emphasis on some) this is true. As any good insurance agent/broker knows the guaranteed value of a whole life insurance contract cannot be partially surrendered (that would screw up the whole guaranteed thing) and must be accessed via policy loan. This, however, is not true of any amount of cash value created by paid-up additions.

Technical factual correction aside, given the allegory to the darkside-ish corner of the lending industry, I figured we take a day and evaluate the merits of whole life insurance loans vs. those of similar loans employed in personal and even business finance.

And technically when I say whole life insurance I don’t really mean to be exclusive to just that product as what follows could be applied to other forms of cash value life insurance. However unlike those who work for real media organizations I will actually make the differentiation by noting that whole life insurance is not universal life insurance.

Borrowing Money in America

There are, of course, a few different ways one can go about borrowing money in the United States, and there are a few different purposes for borrowing money. The traditional items are large purchase items like real-estate, and moderate purchase items like automobiles. Then there are the loans made for smaller consumables like appliances, recreational vehicles, and various equipment. Real-estate and automobiles have specialized lending products available specifically for their purchase, everything else on the other hand can be a bit of a grey area.

None of this is particularly important, except for one noteworthy point. Loans issued with collateral (also frequently called secured loans) tend to have dramatically lower interest rates because the lender has a higher probability of recouping some or all of its costs of the borrower doesn’t pay back the loan.

Given this, it’s not counter-intuitive at all to note that mortgages (loans that are made pledging a piece of real-estate as collateral) tend to come with low interest rates. The reason being if the mortgagor suddenly bails on the repayment, the mortgagee simply takes the underlying pledged collateral (the real-estate) to satisfy the loan obligation.

There are, essentially two ways to borrow money, one way is to pledge collateral to guarantee the loan obligation from loss to the lender.; the other way is to not do this. If you choose to not pledge collateral, either because you don’t want to or because you don’t have it to pledge, then you have taken out what is known as an unsecured loan. The most ubiquitous unsecured loan in America is any loan created by use of a credit card—yes I do realize student loan debt far exceeds credit card debt balances now, but there is a far greater number of people who have credit cards than who have student loans.

Since a loan that has no collateral backing it is riskier to the lender, there is a correspondingly higher interest rate to account for the greater risk exposure for making the loan.

In addition to credit cards, one can take out a loan for practically any reason he or she wishes by going to a bank and filling out a loan application. This is known as a personal loan and most are issued with no collateral to back up the loan. Not surprisingly, interest rates on such loans are closer to credit card rates than mortgage rates—approximately 11% national average according to the Federal Reserve.

But, one can take out a personal loan with a dramatically lower interest rate. All one needs to have is collateral to pledge for the loan. A common practice within bank lending is to pledge ones money market account or certificate of deposits as collateral for a loan, if you do this the bank will significantly cut your interest rate down (there’s a personal finance tip of the day from the Insurance Pro Blog for you), and how much lower?

According to the Federal Reserve the average interest rate on a secured personal loan is 2% over the stated yield on the account pledged as collateral. Is this significant? According to Bankrate the average money market account across the company pays a measly .11% APY. So the loan goes from roughly 11% when unsecured to about 2.11% when secured. Sweet!

But Wait, 2% above the Yield?

That 2.11% interest sure sounds nice, but let’s not forget that’s 200 basis points above the yield you get on the account that is pledged for collateral. When it comes to whole life insurance, not even those jerks who practice direct recognition whack you that hard. A negative spread of 200 basis points is where we’d identify an oppressively bad universal life insurance contract (one that certainly doesn’t deserve to be used for cash accumulation purposes).

Let us not forget that when it comes to life insurance policy loans there is:

  • No loan application for credit worthiness required
  • Usually no origination fee for the loan
  • No need to prove income to repay the loan
  • No requirement to repay the loan on any set schedule
  • A non-amortized simple interest loan where interest due is based off loan balance at policy anniversary
  • No down-payment or positive equity position when purchasing items like real-estate or automobiles
  • No reporting to credit bureaus meaning they do not affect credit rating, debt utilization ratio, or debt-to-income ratio

And despite all of this, the spread between what you earn on the money in the policy and what is due in interest is generally a few basis points and in some cases, a positive spread in the policy holders favor. Also, it’s important not to overlook the fact that credited interest and dividends on cash value compound, while interest on a policy loan is only simple interest.

Pay Day Loans and Life Insurance

I’ve noted numerous times that Dave Ramsey’s position on life insurance is one based solely on ignorance. And I can’t help by think he applies the same principle a friend of mine uses when he informed me some years ago that when it came to the competition he didn’t want to know about it (specifically if it was better than the products he chose to talk to his clients about) because he could then honestly say he was recommending the best products he was aware of. For Dave, there’s a lot of money in those Zander endorsement deals, and so ignorance is quite lucrative.

For those of us without a celebrity endorsement royalty, I guess sticking to fact is all we have…for now. And when it comes to making analogues about whole life insurance loans and payday loans the only thing I can say is there must be something truly special about pay day loans that I’ve yet to unearth. And if it’s really like whole life insurance, than I guess I need go get me one.


6 Responses to “Whole Life Insurance Loans are a Scam”

  1. Aurelien W. says:

    I wanted to ask a question regarding the simple interest charged by the insurer vs the compounding nature of credited interest on the cash value. I’m going to throw out an example and you can comment. For the example I’m going to assume no new premium payments year after year to keep the numbers simple.

    Account Cash Value: $10,000
    Dividend rate: 4.75%
    Loan rate: 5%

    Say I take a loan for most of CV, $9,500. My understanding is that interest is charged up front, so $475 will be added to the CV taken, leaving a CV of $25.

    At the end of the year, I receive my dividend of $475, so my CV goes to $10,000+$475-$9,500-$475= $500

    At the start of year two, they charge the $475 interest for the loan again (this is where the simple interest kicks in, since technically I owe them $9500+475 from the first year), leaving CV of $25.

    At the end of the year, I receive a higher dividend of $498 ($10,475*4.75%), so my CV goes to $10,475+$498-$9,500-$475-475= $523

    This shows how the credited dividend is being compounded, but the interest charged is not. The first year the interest gained and interest owed were the same, but the next year interest gained was higher already.

    Two questions:

    1. Is my example here correct?

    2. What happens if I took out the $9,500 loan and repaid it in 6 months, would half the interest charged of $475 be re-credited to me?

    3. What if I made 5 payments of $1,900 ($9500 total)? What would I owe in interest?

    Thanks in advance for the response.

    • Brandon Roberts says:

      Hello Aurelien,

      Interest can be chaged either in advance or arrears, and arrears is typically more common.

      Interest will compound if allowed to capitalize (i.e. not paid at the end of the year when due).

      If you paid the loan off 6 months later what happens depends on the companies approach to charging interest. If charged in advanced, then you’ll have to pay 6/12 of the interest charge. If in arrears, there will be no interest charge.

      For companies charging in advance, you can often get it refunded if you ask to have it refunded.

      The 5 payments again depend on the interest charging method. If in advance, then the interest is charged fractionally per month. If in arrears then nothing.

      • Aurelien says:

        Thanks Brandon,

        What companies charge the interest in arrears? That seems like a pretty nice deal, having the possibility of taking out a loan for 11 months and paying it back in full with no interest.

        • Brandon Roberts says:

          Actually there are probably more companies that charge in arrears than charge in advanced. From our whole life list, MassMutual, Penn Mutual, MetLife and Ohio National all do.

  2. Michael Sparks says:

    I’m looking to replace my mortgage with an Interest Only+ WL banking policy.

    I’m just having a hard time wrapping my head around how this works.

    Lets say we have a $90,000 current mortgage at 3.5% with a 15 year fixed. Payment is $1000 per month with P+I+Escrow.

    Is it possible to take out an interest only at 2.8% for 10 years with a $218 per month payment then fund a WL policy which you put $800 per month into then draw that out in the form of loans to put toward the home?

    At the end of 10 years would you not only own the home but also have $90,000 plus back in your “own bank”?

    • Brandon Roberts says:

      Hi Michael,

      While you could be leveraging the money that you saved in the whole life policy (i.e. earning interest and dividends on it) you wouldn’t have $90,000 available to you after 10 years if you used loans from the policy to pay off the mortgage at year 10. To be clear it will exit, and you’ll earn money on it, but it won’t be available in full as a large portion of it will be pledged as collateral for a policy loan that was used to payoff the mortgage.

      It’s entirely possible to set up a policy that is capable of having the money to payoff the mortgage in 10 years if you fund at $800 per month for 10 years. You’ll want to consider the following:

      1. Do you plan to place $800 into the policy after year 10 (if you don’t it’s not a deal breaker, just requires some more careful attention to the policy design).

      2. Do you plan to pay down the loan you will create when to payoff the mortgage? It’s not necessarily a requirement, but this will most likely work best if you approach it with that plan in mind.

      This will work. You should ensure that the rates are correct and that the payments are correct. You should also be sure to factor in any misc. fees on the mortgage when it is originated.

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