Interest rates are on the rise. Mortgage rates are up. Treasuries are at levels we haven't seen in a while. Inflation is top of mind, and the Fed will likely continue raising rates until lofty inflation rates cool down–inflation levels we haven't seen in a very long time.
So with rising interest rates comes potentially rising loan interest rates on some whole life and universal life insurance policies. Will those rising loan rates spell trouble for policyholders? Probably not. But not everyone is necessarily in the clear.
The Cost of Borrowing Against Your Life Insurance Policy Could Increase
Let's start by addressing the easy one–life insurance policies with fixed loan rates. Policies with fixed loan rates obviously will not experience an increase in loan costs. Their rates are fixed and they do not move.
For policies with variable rates, those rates are generally set by some sort of benchmark. The most common benchmark life insurers use to set loan rates is Moody's Corporate Bond Rate for Aaa Seasoned Debt, which sits a little above 4% presently. Some insurers use a different benchmark that is less reconcilable than Moody's index. There's a good chance that many of these policies will have higher loan rates a year from now than they presently have.
Will this necessarily spell pain for policyholders? That depends entirely on what exactly they are doing with their policies.
People who borrowed against their life insurance with short-term intentions may end up paying a little more interest for their loan than originally intended. This is still likely way cheaper financing than they would have achieved elsewhere and will remain cheaper versus the options that will exist under prevailing interest rates.
In other words, life insurance isn't immune to the rising interest rate environment reality of money becoming more expensive, but it's also going to maintain its competitive position within the marketplace. It's far cheaper debt than many business loans, credit card rates, most car loans, and certain mortgages.
In addition, life insurance will benefit from the fact that money is becoming more expensive. Interest rates drive the primary accumulation mechanism of life insurance cash values. So rising rates may mean more financing expenses, they will also mean more potential cash value accumulation.
In fact, for those holding direct-recognition whole life insurance with a variable loan rate, any increases in loan interest rates will also mean an increase in payable dividends on cash values acting as collateral for a loan as those dividend rates are generally pegged to the loan interest rate.
Those using loans to generate retirement income are maybe in a situation of reduced income expectations if loan rates are higher. There's a lot to unpack on this.
If cash value accumulation also rises, this potentially offsets the increased loan cost. Depending on the amount of income being generated, the increased loan cost may or may not impact the amount of income taken now or in the future.
If loan rates go back down, it's possible this increase need not impact income taken from a policy.
But there are some risks that are larger with some policies.
Non-direct recognition loan projections assumed a certain spread between dividends and loan rates. If rates go up, that spread is less. This can have a multiplying effect on generatable income. We covered this a few years ago. If non-direct recognition policyholders are using their policies to create income, now is a good time to revisit the income plan.
In the same context, some indexed universal life policies using variable indexed loans may want to revisit plans for income if loan rates have risen. The same multiplying effect is at play.
We Most Likely Need to Calm Down
Chances are very high that these increases are temporary in a long-term context. We'll likely find that interest rates rise and fall and 10-20 years from now, everything is more or less the same in terms of performance expectations. The United States does not have a temperament that is conducive to sustained inflation. That's not to suggest there is absolutely no chance of short-term discomfort from the Fed's attempt to get its hands around the problem. But it's highly unlikely that the resulting interest rates will remain extraordinarily high.
Also, it's important to note that this equation does balance out eventually. Higher interest rates will drive variable loan rates up, but they will also drive dividends up. Higher dividends result in higher cash value at least partially offsetting the increase in borrowing expenses.