With the Fed's ongoing battle with inflation, we're now seeing interest rates that haven't existed in a few decades. Many of us can't remember a time in our adult lives when the cost of money was so high. Not surprisingly this is forcing some changed behavior when it comes to borrowing money. We started the year with mortgage rates around 3%, and now they sit around 7%. While many people will tell you this is brand new territory for Americans, older folks know we've been here before.
In fact, many have expressed concern for what they received as artificially low-interest rates sustained by the Fed's policy of Quantitative Easing following the collapse of financial markets in 2008. We all enjoyed a prolonged period of low interest rates that made borrowing money seem like it had virtually no consequences. Those days are now gone, and it's likely we'll have a substantially higher expense to borrow money, so now it's time to strategize on the cheapest ways to borrow money when we need it.
Mortgage Rates Doubled this Year
I mentioned earlier that at the beginning of 2022, the average 30-year fixed home mortgage (non-jumbo) was around 3%. Now it sits at 7%. To quantify that for you in real dollars, let's look at the monthly payments required for an “average” home in America. According to Fool.com the median home price in the U.S. as of the first quarter of this year was $428,700. Assuming a 20% down payment, a 3% rate on a 30-year fixed mortgage, and no points your monthly mortgage payment on this house would be $1,446–this assumes that you pay property taxes and municipal utilities yourself and not out of escrow.
The same mortgage on the same house today at 7% will require a monthly payment of $2,284, that's $838 more per month, $10,056 more per year and $301,680 more over the lifetime of the loan.
For years, we noted that life insurance loans were an option to purchase houses. Using the life insurance loan as an alternative to a traditional mortgage came with a few benefits–namely a much more flexible repayment schedule, an alternative interest calculation that did save you money, and no impact on debt-to-income ratio if you needed to borrow money for some other reason. But, mortgage rates were so low, it still made a lot of sense for a majority of people to opt the traditional mortgage route because the interest they paid on those loans was still net-net cheaper than the loan charges on a life insurance policy. That is no longer the case and this highlights a key attribute of life insurance contracts–they tend to be way less volatile than most traditional financial tools.
For example, I have a whole life policy that uses a variable loan interest rate. It's tied to Moody's Index for Seasoned Aaa bonds. At the beginning of 2022, that index sat at 2.79%; today it's right around 5%. But my whole life policy has a 5% floor interest rate, meaning it wouldn't have moved as Moody's rate climbed from 2.79% to 5%.
What's more, my life insurance contract stipulates two very important things. First, the loan rate can only change once per year. Second, it can only change if the change will be more than 0.25%. So until Moody's index gets to 5.25%, my loan rate isn't going anywhere. And if it does, it still doesn't change until I reach my policy anniversary date. Pretty cool.
If you financed the same home we mentioned above with a 5% loan from a life insurance policy, you don't have an actual loan payment you have to make, but if you used a mortgage calculator to determine what would be a reasonable payment schedule, that comes out to $1,841. You could do that, and 100% of the payment goes toward the principal. If you did this, you'd actually pay the loan off in 27 years and 10 months. This happens because the loan interest isn't amortized on a life insurance loan the way it is on a mortgage–where the majority of your payment for the first several years is interest and a sliver of it pays down the principal.
Auto Loans are on the Rise as Well
As of August of this year, the average auto loan interest rate on a new car for someone with a credit score in the highest quintile (750 or above) was 8.98%. For a used car, it was 9.23%. For those who fall into the second highest quintile (700-749) the average rate on a new car was 10.94% and 11.19% on a used car. It's been a long time since those with stellar or near-stellar credit were offered financing on vehicles in the double digits.
Again, that 5% life insurance policy loan is looking mighty attractive.
In fact, I can use a personal story to review how life insurance can compare to traditional financing, because I recently had to buy a new car.
I didn't really want to given what's happened to car prices in the past year. But my 11-year-old Volvo wagon with just under 200,000 miles on the odometer prematurely ate through its last set of tires (they had fewer than 10,000 miles on them) and I decided I was done trying to figure out why.
So off to the dealership to buy a shiny new Volvo.
But I did something very out of character, I financed the purchase. Well, sort of. My tires were bad–the old Volvo had a bad habit of prematurely wearing tires–and living in Vermont means the “local” Volvo dealership isn't right around the corner.
I was a little nervous driving the old car there, I definitely didn't want to drive it home. While I had the money to purchase the car, it wasn't sitting in the checking account; I knew I needed time for the money to transfer. So we financed it in order to leave that day with it.
The financing terms were 6.64% on a 72-month loan financing a little over $56,000–a ridiculous price for a car, by the way. Lucky me, I guess I managed a rate that's under the national average–I'm not special, it just worked out that way.
Total finance charges according to the disclosure I received from the dealership would be $12,278.50 if I carried the loan to term. I didn't. the loan didn't survive the week. But what does financing this with a life insurance policy loan look like?
Assuming a 5% loan rate, the payment that I “should” pay every month is $800.12–that's $151 fewer dollars than the $951.27 the bank-financed loan required. The loan is gone after 6 years and 11 months. The total interest paid (i.e. total finance charged) is $9,736.12–saving me a ton of money vs. the bank loan.
Let's not forget that the entire time the loan is outstanding on the whole life policy, I still earn guaranteed interest and still received dividends from my whole life policy. In other words, my cash value balance is still growing despite the fact that I've used some of my policy's money to buy a car.
These Conditions will Likely Remain
Higher interest rates are likely to remain a thing for a while. Life insurance loan rates relatively speaking will likely remain low. We warned people about this years ago. The important message here is the mechanics of life insurance and how it operates in relation to other financial tools.
Sure for a number of years, there was little difference between financing through a bank and financing through a life insurance policy. But if interest rates rose to levels many people agreed were more realistic, then life insurance held an advantage. It was difficult to get people to see that forest through the trees, but it's becoming a lot easier these days.
Owning life insurance creates options, and as time goes by life insurance contracts have a tendency to get financially stronger as the policy owner tends to become financially more vulnerable–age has a way of doing that to us.
And lastly, as rates rise, so do whole life dividends, making this an even sweeter deal.