Introduction
What I want to talk about today is something we see quite a bit with real estate investors and business owners, and it is often a cause of frustration.
It involves taking out a cash-value life insurance policy when you are interested in funding the policy and borrowing from it.
You want to take money from the policy, invest it in your business, and acquire more real estate, and you like the idea that once the money flows through the cash value of a whole life insurance policy, it's forever at work for you; it continues to compound.
It is a beautiful feature of a life insurance policy, and frankly, that is why so many people buy it.
Understanding the Cash Value and Borrowing Dilemma
But where do people get frustrated here and ask the question?
Why would I do this?
Why would I put money into a policy?
It has to do with the fact that if I actually measure what I am growing by the cash value, what it's earning could be 4%, and if I look at what I'm borrowing at, it's 5%; it's a negative spread.
I looked at my policy. I say, Wait a minute. When I actually crunch the year-over-year growth, I'm earning about 4%, but when I borrow against it, the cost to borrow is 5%, so it's costing me 1%.
Whereas if I had my money in the bank or leveraged from another source, I would be in a much better position because it wouldn't cost me anything.
I could just take money out via cash from my bank account and make a property purchase. And yeah, you could argue that hey, it's no longer compounding if it's in a bank account; there are pros and cons to everything.
But I want to address this point, and we're going to do so in the next article as well. We're going to look at some numbers.
But to start, we're going to look at the topic of a dividend rate compared to a loan rate. We're going to discuss this and then the net earnings rate in the policy because this is a topic of confusion that a lot of people look at and get confused about.
I just spoke with someone today who was looking to put in $1,000,000, $2,000,000 actually into a cash life insurance policy, a whole life product, and he said, Hey, this makes perfect sense.
The Discrepancy Between Earnings and Borrowing Costs
I'm earning 5.5% on my money because that company's dividend rate was right around 5.5%.
Now you've got that situation where you've got to provide education for the $2,000,000 you're looking to pay in, and to tell someone that you're not actually earning 5% or 5.5% from a sales perspective, people can be afraid to do that.
Now I'm in the position where we didn't tell him he was earning 5% of what a competitor did, but at the same time, going back to business coaching, do not trash your competition; don't do that, but that's another topic.
So, to get to this point, if you are earning a dividend of 6%, you can borrow from the policy at 5%.
What does that sound like?
That sounds pretty good. I got a positive 1% spread, and we see this being marketed frequently. The thing is, if I have a dividend rate of 6%, that would tell you, as a consumer,
what? If you've got a cash value of $100,000 in your policy and I have a dividend of 6% or am earning 6%, how should I see the cash value grow by that year? $600,000, 6% of $100,000.
The thing is, if you were to actually look at the cash value growth on the policy, look at any of our articles, and you'll never see that being the case.
The Importance of Net Earnings Rate
The reason is that a dividend rate on a life insurance policy is always a gross rate that is credited after the company's insurance expenses, including everything included in purchasing that actual life insurance policy.
No matter how low we drive the insurance expenses, we always minimize them. So what I want to look at is not the gross rate, not what's on paper, but the net numbers.
The insurance company will refer to this as the IRR, which stands for internal rate of return, and then those numbers might look like this: I'm earning 4%, which is a safe internal rate of return for the money's liquidity. I can access it anytime I want.
It's also tax-free if I do things right and don't trigger a taxable event like a MEC [Modified Endowment Contract] or anything like that.
So 4% is not bad at all for a safe place to position money, especially earning 4%, but why would I put money in here if I'm a real estate investor and I want to use this product to buy more real estate when I'm earning 4% and it costs me 5% to borrow?
It doesn't make sense, and if that's the pain point, that's the objection. A quick tip for agents out there: don't try to force the issue or say you don't understand.
You've got to compound everything you've got to address someone's objection the same way you would want it to be addressed. So here's how I look at it: How do I improve this?
Because the reality of it is that if I'm earning 4% on a policy, that's what I'm earning. So if I've got $100,000 in cash value compounding at 4% and I borrow out half of it, $50,000,
Improving the Cash-Value Life Insurance Strategy
What's going to happen with the life insurance policy?
We're going to look at numbers in the next article. If I pull out $100,000, you still receive 4% of the full $100,000, as if you never touched it in the first place.
They do that by charging a loan interest rate of, in this case, 5% and also collateralizing the death benefit, so that's how the company does it.
But when you borrow out that $50,000, it costs you 5%, so in the $50,000 outstanding, I'm earning 4%, and it costs me 5%. That's a negative 1% spread, not a positive 1% spread.
So how you can improve this and what a lot of people are doing right now in the present environment is as follows: I'm going to go through two options here.
What they're doing is the second option, or they're leveraging it or considering it as an option.
Direct policy loan.
This has to do with flowing money into a life insurance policy and really doing this. So I have $100,000 in cash value and pull out $50,000.
What's the disadvantage?
There's a higher interest rate of 5%, but the advantage is that I have full control of my money. With life insurance policy loans, I don't have to qualify for them; I don't have to pay them back if I don't want to.
Unless I borrow out too much or almost everything, I don't have to pay it back on any schedule. I've got tons of flexibility.
You, as the policy owner, are in full control of how and when you elect to pay that policy loan back. That's the advantage there.
The disadvantage again is that the interest rate is high relative to what exists in the marketplace right now.
Cash-value collateral loans
So, a huge advantage here is that the interest rate is approximately 3%; you might see them between 3% and 3.5%. In fact, some companies have lower rates than that, or, I shouldn't say, some companies and some banks do. I take my policy to a bank and say, Hey, I've got $100,000 here in cash value. I'd like to assign it to you, the bank, as collateral, and the bank says, Thank you.
Here's a loan with a line of credit for $100,000. Now, when I actually receive that line of credit, the interest rate may be 3%.
I can borrow against it at my leisure, just like a HELOC against a piece of property that I might leverage. A big difference is that the underwriting with these products or with these cash-value collateral loans is typically very minimal.
With banks, they rely heavily on the life insurance underwriting when we first take out a policy, and they understand the cash value of life insurance products.
So it's a quick approval process, usually 1 to 2 weeks. From what I've seen, it's not extensive; I have to provide a bunch of documents and all that stuff, like any other bank loan.
Line of credit-type loan The drawback here is giving up a little bit of control. When I have a loan outstanding, I must make interest-only payments.
It is a loan with a bank, and then the loan terms for the line of credit are typically, depending on the lender, 5 to 7 years. And really, what that means is that when I take that loan out, it may be intact for, say, 5 years.
At the end of 5 years, the bank may want to review or assess my situation again and put me through the initial underwriting, which is again a 1 to 2-week process.
But at the end of 5 years, if they say, Hey, as a bank, we're not comfortable with these types of loans anymore, they could pull it and say, Hey, we'd like our money back.
You have to pay it off and borrow from the policy to pay it off, however. Does it happen? No, but it's good for awareness.
But in any event, it's a nice option to be aware of because now, all of a sudden, if I've got a bunch of money in cash, which we see a lot of people in this situation where they say, I like my cash because it is liquid.
When an opportunity pops up as a business owner or real estate investor, if I have cash available, that gives me the ability to move quickly. Now that's the advantage.
The drawback is what?
I don't earn anything; maybe it's 1% if I've got a huge amount of cash and I'm a premier account holder at Morgan Stanley or something like that.
But for the most part, it pays next to nothing because I have liquidity, so that's the drawback. Now the advantage of a cash-value life insurance product, which is exactly what banks do, by the way, is that I actually see it earn.
When I say exactly what banks do, if they've got money sitting there doing nothing, they can position it in a product where they actually see it grow year over year.
which, by the way, is a tax-free yield as well if I don't trigger an MEC and if I don't lapse it with a gain or anything like that. We've got other content on that. But effectively, I've got a tax-free yield—call it 3% to 5%.
If all things are set up properly, now I can borrow at 3%; maybe even better, maybe it's 2.5% to 3.5%, whatever it might be, but I can borrow at 3% while I'm earning 4%. Now I've got a positive spread. This loan is tax-free if it's for business purposes.
If it's for a business or a real estate investor, it can often be classified as a business loan and then be tax-deductible.
I always check that with the bank or your CPA, as we are not an accounting firm and are not giving out any tax advice or anything like that.
But I wanted to provide some awareness on that because this question comes up:
Why would I put money into a policy?
This is often the only option shown; typically, it's the option on the left, and then an investor or business owner figures this out on their own and says, No, I'm not doing this.
It doesn't make sense, or they find out after it's too late, and then they get frustrated. My point though is: how do I improve this if I can be shown options that may open up my mind to say?
Okay, yes, I want this, but the numbers have to work now. All of a sudden, this makes sense. So we're going to look at some numbers in the next article.
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