I appreciate creativity. When I first started selling life insurance, I spent hours studying the product. Prodding it in various ways to see what it did. When I happened upon a few tricks I could use to manipulate whole life insurance to produce more cash value, I figured I simply arrived at an understanding others kept from me.
As time went on, I began to realize that maybe I figured out a few things around product functionality that other agents didn't know. That whole journey led me down a path of discovery and learning that I still relish. Whenever someone comes along with a new idea, I take notice and welcome the opportunity to potentially learn something.
Over the past couple of years, we received a few emails asking for our thoughts on insurance marketing concepts that effectively “self-financed” the premiums of new policies. The idea, in a nutshell, is to capitalize on the unique features of life insurance policy loans to purchase even more life insurance and try to scale the positive spread between loan interest and policy value accumulation.
If using a life insurance loan to acquire an appreciating asset is a good idea. And life insurance is itself an appreciating asset, then it only makes sense to borrow as much money as possible to buy more life insurance! Right? Let's explore.
Leverage Ain't Just for Rich Folks
It seems like the new buzz word among all the super-secret “investing” ideas is leverage. If you haven't heard, it's the secret weapon the wealthy have used for years to grow their net worth by speculating with other people's money. It also plays a vital role in several get-rich-quick schemes (mostly involving real estate) but pay no mind to that.
I'll take a break from the sarcasm for a moment and explain the honest applications of leverage.
Let's say your best friend from back home calls you up to let you know that he's developing a high-rise in a very coveted downtown area and looking for investors. He expects to complete the project and sell all of the units within the next 24 to 36 months. You like the idea and have the cash on hand to invest, but you also own several other assets.
You call up “your guy” at the bank and tell him you'd like to pledge a few rental properties you own as collateral for a loan. He happily readies the documents and you use that money to invest in your friend's development.
36 months later the last unit in the development sells and you now have all of your initial investment back, plus a lot more money. You retire the outstanding balance on the loan you took out and pocket a nice sum of money.
Your cost in this endeavor? The interest paid on the loan. This makes your return on investment look amazing, but also during the entire 36 months you had the other money still ready to deploy on other investment opportunities if one popped up.
Leverage creates scalability for investing because it allows you to minimize the initial cost of acquiring an asset. Instead of liquidating some other asset you held. You simply tapped the equity in an asset you had no plans to sell but held equity you couldn't (or wouldn't) otherwise use.
It sounds like a pretty simple concept, but it has a quickly multiplying number of facets that make it a bit more complicated.
Using Life Insurance to “Unlock” the Power of Leverage
Trying to use life insurance as a means to “unlock” the power leverage is not a new idea. Numerous past attempts sought to invoke the notion of leverage as a shiny new reason to buy life insurance. Some ideas better than others, but the majority are big-time losers.
The idea that you take life insurance and borrow against it to buy more life insurance, takes a bold twist on how life insurance loans work. Let's understand how this potentially gets off the ground (spoiler alert, it doesn't).
Some life insurance companies have life insurance policies that currently have a positive loan spread or theoretically have a positive loan spread in favor of the policy owner. This means that when a loan exists, the policy owner pays an interest rate that is lower than the rate of accumulation on cash value pledged as collateral for the loan. Let's use an example to make understanding crystal clear:
[thrive_text_block color=”blue” headline=”Loan Spread Example”]Suppose you have a life insurance policy with $100,000 of cash value. You decide to take a loan for $25,000 against the policy. The loan rate is 5%. This means interest will accrue on the loan balance at an annual rate of 5%. That's $1,250 in absolute dollars. The accumulation rate on the policy's cash value is 7%. In other words, the interest accrued on the cash value is 7% annually. So you'll earn $1,750 on the $25,000 pledged as collateral for the loan. This represents a positive loan spread of 2%. The loan grows at 5% interest, while your cash value grows at 7% on the same amount. In this example, you net $500 each year because of the positive spread.[/thrive_text_block]
Keep in mind from the example above that you also earn the same 7% on the other $75,000 that is unencumbered. So you actually earn more than just $1,750 on your cash value. This point isn't particularly important to the loan spread discussion, but it's worth noting.
When a positive loan spread works out it's a great thing. But life insurance isn't the only financial tool available to you capable of achieving a positive loan spread. There are plenty of other assets out there that you can pledge as collateral and those assets could appreciate at a rate higher than the loan interest rate.
Real estate is a common example of this. If you open up a line of credit on your house and pay 6% annually on the LOC while your home appreciates at a rate of 7%, you have a positive loan spread.
Life insurance does have some unique characteristics that make it arguably the safest place to pull off secured debt financing:
- The lending feature can be entirely “in house.”
- Most life insurance products cannot depreciate in value.
- Life insurance is liquid.
- Life insurance always has a mechanism to retire the loan
In House Lending (though Not Required)
All life insurance policies that have cash value include a feature to borrow against the policy. This lending feature is offered through the life insurance company and it functions as an automatic way to access the benefit of your cash surrender value. The loan requires no credit check, no financial underwriting, and no application process. You simply instruct the company how much money you want, and you'll receive it in about a week (sometimes sooner).
Additionally, life insurance loans, are not public loans. So they do not affect your credit score and they do not count towards your debt-to-income ratio. This means, if you choose to secure traditional bank financing, you are under no obligation to disclose your life insurance loan to the bank.
On top of this, life insurance loans function differently from traditional bank loans. They do not come with a set repayment schedule. They are not amortized, and they have no additional costs beyond the interest.
When a life insurance loan exists, you the policyholder are free to repay the loan under whatever schedule you deem appropriate. The life insurance company will not send you a payment booklet. They will not bug you if you make a payment for one month and not the next.
They also will not tell you that you need to repay the loan within a certain number of years or else need to refinance the loan. The terms are indefinite. This gives you the flexibility to repay the loan (if you chose to) on your schedule.
Life insurance companies do not amortize interest on life insurance loans. If you look at the repayment schedule of a traditional bank loan and notice that a large percentage of your payment in the early years pays the interest while a small amount pays principal, you have some idea of how amortizing interest works. Amortization is the process of spreading interest across your payment schedule. Banks use this method to earn as much interest as possible early on and then recoup their investment in later years.
This can significantly drive up the cost of borrowing if you're forced to refinance the loan. On a life insurance loan, you pay only principal with each payment, and then interest is added (or paid by you) at the end of the policy year.
Life insurance loans have no additional fees beyond interest. No origination fees, no late payment fees, no early payoff fees. The only cost to borrow against a life insurance policy is the loan interest charged against the policy.
But in addition to all of this, you don't have to use the in house loan feature if you don't want to. You're free to go to your bank and tell your friendly banker that you want to borrow money and pledge your life insurance policy as collateral for the loan. They'll gladly accept it in most cases, and usually offer you much nicer lending terms because you are securing the loan with a very safe and predictable asset.
Life Insurance Policies Don't Depreciate
Most cash-value life insurance policies grow at a guaranteed rate. The only exception to this is variable life insurance, which can place the cash value in mutual funds that can decline in value. We don't recommend you use any of the strategies that we talk about on The Insurance Pro Blog with variable life insurance. Instead, we focus on the guaranteed products that do not put you at risk of losing your money.
So unlike real estate, stocks, or any other asset you can pledge as collateral for a loan, life insurance will not experience a loss of value due to market conditions, so you drop the risk of being underwater when borrowing against it.
This being said, there are some forms of indexed universal life insurance that could lose a small amount of value if the market index it follows is flat or down for the year. This isn't due to the decline in the market. It's due to the zero-interest payment on the cash value and the deduction of insurance expenses from the policy. This deduction of expenses typically averages less than 0.5% of the cash value in the policy.
In any event, most insurance policies (excluding variable life insurance) appreciate constantly. Indexed products can lose a small amount of value if the index is down for the year due to insurance expenses, but you'll most likely have many more constantly growing years than you will minor reduction years.
Life Insurance Liquidity
You can take the value of a life insurance policy out of it anytime you want. You aren't subject to some sort of redemption qualification. You also aren't boxed into some sort of tax law regarding your age. You can also extract value from a life insurance policy without tax consequences, which can unburden trickier liquidation considerations associated with qualified retirement accounts.
Life insurance companies traditionally send funds requested from a life insurance policy in a few days to a week from request, and you can access this value discreetly (i.e. you do not need to liquidate the entire cash value).
Always a Way to Retire the Debt
When you pledge life insurance as collateral, you'll always have the cash value to retire the debt obligation if you need to. Because life insurance is very stable and doesn't depreciate in value, you don't have to worry about margin calls. If you happen to die while the debt obligation is outstanding, the death benefit will take care of paying off the obligation for you.
Use Leverage to Buy Assets
Because life insurance enjoys the above-mentioned features, it's a favorite tool to acquire assets through leverage. This was a key point to Nelson Nash's Infinite Banking Concept®.
So if life insurance is a great way to use leverage to acquire assets, and if life insurance is itself a great asset, it should follow that you can leverage life insurance to buy more life insurance…right?
While it might sound like a good idea framed in that context, this idea is a non-starter. I'm sure someone somewhere can come along and show me a unique example where taking a life insurance policy loan to buy another life insurance policy worked out in someone's favor. I'm not denying that highly specialized circumstances could exist that would make this a viable option.
What I'm staging a specific attack against today is a sales technique that has grown in popularity seeking to sell life insurance with the plan to take loans against it to specifically buy more life insurance using leverage as the magic trick that makes it all come together for you.
Trying to Make the Math Work
While I was skeptical from the outset, I attempted to convince myself otherwise that this was a viable strategy for life insurance. So I looked at scenarios using indexed universal life insurance as a tool to accomplish this.
I chose indexed universal life insurance because it has the most leverage potential. The index return interest rate can be substantially higher than the loan interest rate in some circumstances. Indexing isn't as tied to insurer general account returns as whole life dividends in the case of dividend recognition, so this makes the spread between the index interest rate and loan interest rate less of a concern as it grows.
Using a 40-year-old male with a $20,000 per year premium I first looked at a policy that simply ignored all of the borrowing to buy new policies. Then I looked at borrowing money after five years. The loans taken are another $20,000 to buy a second policy. I'd continue to pay the $20,000 premium to the original policy.
Then I looked at a third scenario where I again used loans to buy a second policy after year five, and then took loans from that policy five years later to buy a third policy–continuing to pay the $20,000 premium to policy #1.
I assumed a 6% index credit rate for the indexed universal life insurance policy, which is reasonable given its indexing features. But this 6% assumption is below the maximum allowable index crediting rate. All loans used the indexed loan feature. Here's a chart of the projected cash value results for all three scenarios at ages 65 and 85.
|Age 65||Age 85|
|Scenario 1||$ 1,076,298||$ 4,704,874|
|Scenario 2||$ 932,456||$ 4,360,244|
|Scenario 3||$ 818,027||$ 4,344,312|
As you can see the scenarios that used loans to buy new policies (scenarios 2 and 3) the cash value is less than the policy where I do not take loans and buy a new policy. This isn't really a surprising result, but I'll get to why that is in just a minute.
I needed to push the limits on this idea, so I went back and increased the index interest rate to the highest allowable for projecting cash values. Perhaps this would provide enhanced cash value needed to make this idea look viable. Here's a table of those values (I skipped scenario #2 on this one, I figured looking at both extremes would tell me what I needed to know):
|Age 65||Age 85|
|Scenario 1||$ 1,157,914||$ 5,456,810|
|Scenario 3||$ 958,975||$ 5,823,540|
Again taking the loans lags, but interestingly not forever. By age 85, there is an advantage to taking loans and buying new policies. But this only works when we max out the index assumption, keep that in mind.
Why Borrowing Against Your Life Insurance to Buy more Life Insurance Doesn't Work
This idea doesn't work, at least not to enhance your net worth because life insurance has acquisition costs. You can avoid these costs by simply focusing on the original policy. But more importantly to the leverage point, life insurance is not a fast appreciating asset. It's a fixed interest play that has expectedly lower returns given its low-risk profile. Using leverage to acquire assets works best when speculation is at play.
In other words, I could liquidate a $500,000 position and purchase some real-estate that might be worth $1.5 million three years from now. Or I could simply leverage the $500,000 asset and buy the same real-estate. My actual cost to acquire the asset is then just the interest I pay on the loan, and the $500,000 asset I didn't liquidate will hopefully continue to grow in value.
The reward for this might be a ~$1 million gain to me. That's worth borrowing money.
If I borrow $500,000 to buy life insurance it won't be worth the original $500,000 for a few years. And even once it achieves a positive return, it'll be a long long time before it's worth $1.5 million in cash value. That's simply too much time and not enough upside to warrant the risks associated with leverage. Leveraging assets to acquire life insurance doesn't work if the goal is to acquire cash value.
It's a stupid idea championed by unscrupulous salespeople. The only thing this idea does really well is to generate new sales and new sales commissions for the people that promote it.
The Risks are Significantly Higher than Suggested
Leverage involves risk. In fact, leverage involves magnified risk. It magnifies the potential gains but also magnifies the potential losses. Putting life insurance in the mix does not eliminate the risks uniquely posed by leverage.
Despite this, those who sell this idea of borrowing against life insurance to buy more life insurance suggest that the risk-free nature of life insurance eliminates the risks one normally faces when employing leverage. This suggestion is utter nonsense.
Borrowing against life insurance to buy more life insurance seeks to take advantage of the potential loan spread available on certain life insurance contracts. But this spread is not guaranteed. And, frankly, we really don't know if this spread will exist in the future. Things could change, and that introduces plenty of risk in this equation.
Indexed universal life insurance cap rates can and do change. A downward adjustment on the cap rate squeezes the potential loan spread of the policy.
In my example above, I have to assume that the indexed universal life insurance product available today, is still available 10 years from now–highly unlikely given past experience.
Leverage is an option advanced investors employ to enhance the potential return of their investments. It's not something you master by attending a seminar in a hotel conference room. Life insurance does present some unique opportunities to use leverage to acquire other assets. But life insurance contracts themselves are poor options for a leveraged acquisition insofar as the focus is on the cash value.
Leveraging premiums to buy death benefit at a discount is a viable option, but only for individuals with considerable assets to pledge for an intermediate-term. And even in these cases, the individual will almost certainly need to be willing to use some cash flow to pay a discounted life insurance premium. That's not a strategy to grow wealth. It's a strategy to protect wealth from forced liquidation and/or certain taxes.