This is another misconception about cash value life insurance that floats around out there, so allow me to help clarify this.
If we look at life insurance as property (and there are MANY comparisons), then we are borrowing against the accumulated cash values in the property – exactly like we would borrow against the equity of a home. When we borrow against the value of a home, we pay interest. This works exactly the same way (except it is not tax-deductible).
Within a life insurance illustration, there are promises of returns to be made by the insurance company. If or when you borrow against the policy, the insurance company no longer has those funds to generate the promised return. In order to have the revenue to pay the promised returns, interest must be charged.
There are generally two ways to take out life insurance loans – fixed or variable rates. Fixed rates are exactly that – fixed for the term of the loan. One such company has a fixed 8% rate on their loans. The problem with fixed rates is that they may not be competitive for the current interest rate environment. Right now, most variable insurance loan rates are around the same interest crediting rates of the policy, between 4% - 5%.
As far as policy performance, it really doesn’t matter which you choose. Let me explain with some sample numbers:
If you have $100,000 in cash value in your policy, and it earns 4%, you will earn $4,000 for the year.
If you take out a $50,000 loan against the policy values, and your loan charges 4%, you will have loan interest of $2,000 per year.
If you don’t pay the interest back to your policy out of pocket, then $4,000 earnings - $2,000 loan interest = $2,000 net earnings.
If you DO pay the interest back to your policy out of pocket, then $4,000 earnings - $2,000 loan interest + $2,000 interest payment = $4,000 annual policy earnings.
What you're doing is reimbursing your policy out of pocket for the interest charged so your policy will continue to perform and grow as needed.
Sounds simple enough, right? Well, someone will want me to ‘prove’ it… so here we go:
In this example, we are paying $10,000 per year on a OneAmerica Whole Life Select 95 maximum-funded whole life policy for 10 years that was purchased at age 35, with standard, non-smoking underwriting classification. (This illustration is for an example only and is NOT a solicitation to buy insurance.)
In year 11, we borrowed against the policy with a $50,000 loan while still paying the annual policy premiums of $10,000 per year + the annual loan interest being reimbursed back to the policy (paid out of pocket to the policy). In year 15, we repay the original $50,000 loan.
What we’re looking for is if you can keep the interest payment that you are paying back into the policy (reimbursing the policy for interest charged).
Year 11: Is the year we borrow against the policy.
Notice the dividend treatment in year 10 vs year 11, as this is a non-direct recognition policy. That means that when dividends are paid, it does NOT take the outstanding loan into account as to how much of a dividend to pay.
The loan interest per year is calculated to be $2,640 each year based on current interest and loan rates. (Notice that the payment per year increased from $10,000 to $12,639.96 to account for the loan interest.)
Year 12:
End of policy year 11 total net cash values: $66,652
Dividends paid with loan: $2,014
Loan Interest paid out of pocket: $2,640
End of policy year 12 total net cash values: $80,542
$80,542 - $10,000 (current year premium) = $70,542
$70,542 - $66,652 (end of policy year 11 values) = $3,890 total gain.
Dividends paid: $1,806 + Loan interest paid out of pocket: $2,640 = $4,446.
$4,446 year 12 total gain – $3,890 year 11 total gain = $466 net policy gain.
You still have a gain in the policy even while paying loan interest and receiving 'non-direct recognition’ dividend treatment. This is why I say that you can keep the money you were sending to banks and credit card companies when you borrow from your life insurance policy and reimburse the interest payments back to your policy!
The math continues on throughout the illustration until the loan is repaid after 5 years.
My common sense tells me, based on an analysis of these numbers, that the policyholder KEEPS the interest payment that they reimburse back to their policy on any outstanding loans.
Now, what happens if you DON’T reimburse the interest back to your policy each year out of pocket and allow the loan interest to accrue year over year?
Year 12:
End of policy year 11 net cash values: $85,294
Dividends paid with loan: $1,806
Loan Interest Paid Out of Pocket: $0. (Loan interest added to balance of loan.)
End of policy year 12 cash values: $97,436
$97,436 - $10,000 (current year premium) = $87,436
$87,436 - $85,294 (end of year 11 cash values) = $2,142 total gain.
$2,142 – $2,640 (annual loan interest) = $-375. (You will notice this is lower than the previous example.)
I think you’ve got the idea.
By the way, I want to point out something very interesting.
Look at year 16 of the policy in both tables of numbers. This is the year that the loan is repaid in both examples, whether you paid interest out of pocket each year or in full in the 5th year of the loan. They both read: $192,106! This actually matches the policy illustrated performance even if you never borrowed the money!
Why does this work like this?
The loan was only 50% of the cash values at the time the loan is taken out. If the loan was larger, you might not have a gain.
Premiums on the policy are still being paid and new premium is earning more and more return as the policy ages. Just as when we take out a home equity loan or line of credit, we don't stop making our regular mortgage payments. (However, unlike with a home, you CAN skip payments if you need to, as long as you have cash values to help sustain the policy for a period of time.)
Additional policy riders may impact policy performance. This policy had no additional riders at a cost.
Bottom line: Yes, you are paying to borrow against your policy's cash values. However, as you can tell, you DIRECTLY BENEFIT from reimbursing your policy the interest payments back to the policy each year.
Do all policies work like this? I cannot say for certain. Some policies will pay you a given dividend regardless of outstanding loans!
If you would like some additional information on the subject, here is an excerpt from The Tools and Techniques of Life Insurance by Stephen Leimberg on the subject of life insurance policy loans: Click Here
By the way, if you are an entrepreneur or business owner, learning how to use collateral can have FANTASTIC opportunities! Watch this two-minute video to learn more: