One of the greatest advantages of cash value life insurance is the ability to pledge it as collateral for a loan. Life insurance cash values are non-correlated assets to the stock market (assuming non-variable insurance policies), so having a cash reserve available for emergency or opportunity can be priceless!
There are two ways that a loan can be taken against a policy. (Please note that the term is against a policy, not from a policy. Your cash values stay in the policy! Now, the insurance company may make some changes as to how they earn interest, which is what we'll discuss.)
The two ways:
Fixed Interest Loan
Variable Interest Loan
The variable interest loan is the easiest to understand and explain.
The cash values of the policy will continue to earn indexed interest as though no loan was taken against the policy.
The loan will be charged interest according to current interest rates that can and will change as interest rates change. How often will vary by insurer and possibly by contract.
So, how does that work?
Assume you have $100,000 in cash values in your policy that will earn 5% of indexed performance. (I need a number for this assumption; indexed interest has no guarantee of interest to be credited.)
You take a loan against your policy for $50,000 that has an interest rate cost of 5%.
$100,000 cash values earns 5% = $105,000. $50,000 loan with 5% interest = $2,500 of interest charged against the policy.
If you do NOT pay the loan interest out of pocket:
$100,000 + $5,000 - $2,500 = $102,500 + COSTS OF INSURANCE. (That's often not factored into most blog articles, but it's important.)
If you DO pay the loan interest out of pocket:
$100,000 + $5,000 - $2,500 + $2,500 = $105,000 + costs of insurance.
Now, that's the easier explanation.
How do fixed loans or "wash loans" work?
The amount borrowed against will NOT earn indexed interest.
Instead, it will be placed in a "collateral account" to earn a stated amount of interest determined by the insurer.
The amount borrowed will earn a comparable amount of interest compared to the amount of interest charged on the loan.
One life insurance company says this:
Fixed Loan Option
The Accumulation value is reduced by the amount of the Loan and that amount is transferred to the Loan Collateral Account.
Fixed Loan will earn interest at 6% and the Fixed Loan Interest Rate is 6% in arrears.
(The accumulation value is the amount that can earn indexed interest.)
Another says this:
Fixed interest loan:
Years 1-10: 2.91% annual up front charge, guaranteed for the life of the policy; 2% credit each year loan is outstanding on the policy anniversary.
Years 11+: 1.96% annual up front charge, guaranteed for the life of the policy; 2% credit each year loan is outstanding on the policy anniversary.
The questions I want you to be asking yourself is this:
How can the insurance company do this?
Why are they doing this?
What is in it for them? (These are not mandatory requirements required by law, such as nonforfeiture rights.)
First, policy loan interest is an ASSET and REVENUE STREAM for the insurance company. The insurance company should be MAKING MONEY from you borrowing against your policy. The interest charged should be going BACK to the insurance company's general investment account for them to continue to invest. That's not a bad thing. It's just the truth and the facts.
There are two other factors that I keep in mind on these policies:
Increasing costs of insurance on the net amount at risk
Policy lapses and/or policy death benefit reductions are part of the actuarial calculations for their profitability.
Let's go through these.
Between the death benefit and the cash values is the net amount at risk. In IUL policies, the cost on the net amount at risk increases as you get older. It is essentially an Annually Renewable Term policy. This will continue to increase in cost as you get older.
This leads to the second point: Eventually, larger policies will reduce their total death benefit in a way to contain these costs and maintain the tax efficiency of the funds in these policies. One way we know this happens is the inclusion of the "overloan protection rider" on nearly all IUL policies. The overloan protection rider works like this:
Provides protection from lapse due to an outstanding policy loan. The rider may be exercised if you are between the ages of 75 and 120, and the policy must be in force for a minimum of 15 policy years.
The economics behind what that really means... is that when you have essentially exhausted all your cash values in the policy, AND you have met their criteria to activate the rider (your age and policy in-force criteria), they will allow the policy to NOT lapse! This can save you a tremendous phantom income tax bill that failed policies could otherwise incur in the year the policy fails. So it is a huge benefit, but you and your beneficiaries will get very little from the policy at this stage.
Think this through:
If the insurance company will charge higher costs of insurance during the earlier years...
based on a larger death benefit...
that will eventually be reduced
for the benefit of the client...
and they don't have to pay out the larger benefits that were being paid for in the early years (because it's essentially annually renewable term insurance)...
isn't that a great business model overall?
Doesn't that explain why these are good companies to be publicly traded stock companies?
Am I saying that IUL policies are ripping people off? No, not at all. I am saying that this is the nature of these policies and the lifecycle of these policies to ensure that they can provide the benefits the agents promise they will get.
Is there an alternative? Yes, but that's not the point of this article. The point was to simply outline how fixed "wash loans" work. But if you want the alternative... I believe that you either "Fill the box, or you pay the curve." The issues that IUL can have is that it isn't guaranteed to fill the box or earn enough to offset the costs of the curve of annual term insurance.
Guy Baker, PhD, MBA, MSFS, CFP, CLU, ChFC... explains this exceptionally well in this video he produced back in the mid-90's.