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Debt Payoff Strategies With Life Insurance

This post is about leveraging the cash value of a maximum over-funded life insurance policy to payoff high-interest rate credit card debt. By swapping low-interest policy loan debt for high-interest credit card debt, you can efficiently swap out and then payoff a new, more affordable loan. 

Goal 

The goal of this post is to show you how you can both save for retirement and eliminate credit card debt at the same time by putting your money to work in two places at one time.

So if this sounds interesting to you, keep reading.

Fundamentals

It’s important to understand that interest saved is every bit as valuable as interest earned. With the traditional application of The Double Play model, one would leverage the cash value of their maximum over-funded life insurance policy to invest in real estate, for example. If They could borrow against the policy at 4% interest and use those loan proceeds to make an investment earning 10%, for example, they would earn a spread of 6%. And assuming that they were in a 33% tax bracket, they would net 4% after paying the tax.

But what if you could use that same 4% money to make a payment on a credit card charging 20% interest? You would save money by swapping out 20% debt for 4% debt saving 16% annually. This 16% savings is every bit as valuable as interest earned on an investment. Let’s say you had $10,000 of credit card debt. At 20%, the interest expense would be $2,000 per year. However, at 4%, the interest expense would be only $400 per year. If this was the case, the interest savings would be $1,600 per year. That is a substantial savings!

Obviously, I’m simplifying things a bit, since you might be paying down that balance over time. You’ll be borrowing money to pay the interest on the existing debt as well. But it’s important to be aware that the overall expense is still going to be lower. There are an infinite number of different situations people may find themselves in.

I know what you are thinking, you know it can work if you have cash value that you can borrow against, but what if you are struggling to make payments on the credit card and you don’t have money to fund a brand new life insurance policy? Would It still make sense to take what you would have paid to the credit card company and use it to fund a policy?

Advantages

The answer is Yes. As you will see below, it does make sense.

However, before I dive into the numbers, let’s discuss some of the advantages of this approach:

  1. Life Insurance Death Benefit
  2. Financial Reserves
  3. Retirement Planning
  4. The Double Play

 Life Insurance Death Benefit 

It’s important to recognize that the death benefit is one of the intangible benefits of this approach. You may or may not have planned on getting life insurance, but there is no denying that it provides value. And that value isn’t accurately represented in a simple payoff model. If your goal is simply to reduce/eliminate credit card debt,and then start saving for retirement, the death benefit of the policy would be an added bonus. This is one less thing that someone would have to spend their money on.

 Financial Reserves

 It’s always a good idea to make sure that you have a sufficient store of liquid assets available for financial emergencies. It is recommended that most people have enough to cover 6 months of living expenses. Click Here to read an article I wrote on why a maximum over-funded life insurance policy is the best place to keep your financial reserves.

 Retirement Planning 

You should also realize that in the process of setting up a maximum over-funded life insurance policy, You are creating a retirement savings vehicle. The cash value of any life insurance policy can be used to generate tax-free income in retirement.[1] It is also important to understand that when you are borrowing against the policy to pay down the credit card balance, the cash value of the policy never leaves the policy and continues to earn dividends/interest-credits.

It’s very important to emphasize that the insurance company is giving you a low-interest loan with your cash value as collateral. Because the loan has nothing to do with the cash value securing it, this means that individuals can get a much earlier start on their retirement savings.

If someone waits to eliminate their credit card debt before beginning to save for retirement, they are losing the time and potential for compounding interest during the time it takes to eliminate the debt. Time is essential.

 The Double Play 

It’s important to realize that unlike an IRA or 401(k), you can leverage the cash value of a life insurance policy to put your money to work in two places at one time. That means that you don’t have to wait until you retire to touch your savings.

Will it Work?

So does it make sense to take the money that would have been used to make a payment toward a credit card and instead use it to fund a policy? The obvious “Pro” is that the high interest credit card debt is being swapped out with a low interest policy loan. But the “Con” is that until the credit card balance is completely swapped out, no real debt reduction has begun.

The questions we need to answer are:

  1. Would you be better off to take your cash and pay down the credit card balance as soon as possible and then begin putting money away for savings? or
  2. Would you be better off funding a maximum over-funded policy and then borrowing against it to swap out the high interest debt for a policy loan AND THEN paying off the loan?

Analysis 

So let’s try to answer these questions.

As we go through this analysis, let’s use some sample numbers. Let’s assume that our client is a 35 year old  male with $12,000 of credit card debt at 20% interest. Let’s further assume that he can afford to pay $1,000 per month toward the credit card bills. Once the client is done eliminating the debt, he intends to continue saving by reallocating the $1,000 toward his retirement savings. And finally, let’s assume he will earn 8% on his retirement savings and no sales commissions or other fees.

 Status Quo – Directly Eliminate Debt 

So let’s start by looking at the status quo. How long would it take to eliminate the debt by paying $1,000 per month?

The table is showing the monthly balance reduction as each $1,000 payment reduces the balance. As we can see, the debt is eliminated in the 14th month.

It is only after the debt is eliminated that our client could begin to dedicate that $1,000 toward savings. This table shows the growth of his savings over time:

The table is only showing the first 30 months. The entire spreadsheet continues on for 10 years.

 Leverage Life Insurance Cash Value to Eliminate Debt 

So what would these tables look like when we leverage the cash value of a life insurance policy to swap out the debt and then pay it off? One thing that is for certain, we know it is going to take longer to eliminate the debt completely. The client’s $1,000 is going to be reduced by the fees and charges in the policy. Only the remainder can be leveraged. The goal here is to reduce the bleeding of cash by swapping out the high-interest debt for low-interest debt first. Once that is complete, then our client can turn his attention to eliminating the debt.

 Swap Out The Debt 

As with The Double Play, the policies that we use for these applications must be properly designed. This application requires a maximum over-funded policy design and no surrender charges. The client needs to be able to access all of the available cash value.[2]

So how much longer is it going to take?

This table is showing that it will take a total of 30 months to eliminate the debt completely. However, you can see that it is only taking 17 months to swap out the credit card debt. That is three months longer than it took to pay it off directly. You can see the policy loan interest charges continuing from month 17 to month 30.

 Eliminate The Debt 

Another important thing to consider is that once the credit card debt is eliminated, our client is going to stop making premium payments on the policy. How and why would we do that?

A universal life policy allows for premium flexibility. The policy owner can stop premiums anytime. The fees of the policy will simply be deducted from the cash value. In our case, the client is going to take the $1,000 that he was putting toward premium and use it to payoff the policy loan instead. This is going to free up the secured cash value. If you think of policy loans as creating a “hole” in the cash value by the amount secured by policy loans, we are simply filling in the hole. This creates unsecured cash value sufficient to cover the fees and charges of the policy. To a certain extent, you should be aware that it’s a way to create cash value in the policy without the fees associated with paying premiums.

While it will take longer to eliminate the debt completely, one important thing to remember with the latter is that all of the cash value has been earning dividends and interest crediting during the time it takes to swap out the debt and then payoff the policy loans. That means that when the policy loan is paid off, all of the cash value is available to provide retirement income. This provides a big head start on retirement saving.

This table below shows the policy loans. During the first 17 months they are increasing as the debt is swapped out. Months 17 through 31 show the elimination of the debt. The table is also showing the “Net” cash value. The “Net” cash value is the amount of unsecured cash value in the policy. Once the policy loans are paid off, all of the cash value is unsecured.

While I am making an apples to apples comparison with this analysis, be aware that the client can pay toward both premium and policy loan reduction. This means that if they are making more money in the future, they can  do both to help accelerate the savings. The cash value is still growing during the time premiums are not being made, but no premiums are adding to the cash value. The fees and charges offset the cash value growth.

 Comparison of Outcomes 

In retrospect, as I write this, I’m thinking I should have included one more row on my Table showing the total savings in the first scenario. The table is only showing 30 months of data. However, please take note that when our hypothetical client begins his retirement saving after eliminating his high-interest credit card debt, he has only accumulated $16,126 after 30 months. Showing one more month to make a direct comparison would not make much difference.

Our hypothetical client would have accumulated $28,452 of cash value in their life insurance policy after 31 months of swapping and eliminating their debt. While this represents a significant difference in savings, I’d like to refer you over to my posts on using a Life Insurance Retirement Plan. I want you to be aware that the cash value of a maximum over-funded life insurance policy can generate retirement income at 2 to 3X that of traditional retirement savings approaches. So for those readers thinking “Yeah, well the savings in the ‘Status Quo’ scenario are growing at 8% and the life insurance is only growing at 5.25%. It’s going to catch up long before retirement age”, please go check out the articles I referenced in Footnote 1. Our hypothetical client is going to enjoy more retirement income having implemented this debt reduction strategy than if they simply paid off the credit cards directly.

Conclusion

The goal of this post was to show you conclusively that it makes sense to loan against a maximum over-funded life insurance policy to swap out high interest credit card debt. As I’ve shown, interest savings is every bit as valuable as interest earned. The main advantage of this planning approach is that once the debt is finally eliminated you already have retirement savings equal to the amount you contributed toward cash value plus the growth of that cash value. The alternative would be to simply use your money to payoff the credit cards directly AND THEN begin saving for retirement. As shown in my example, this approach resulted in lower overall savings and retirement income.


[1] Learn more about tax-free retirement income from life insurance here, here, and here.

[2] Subject to any holdbacks. Some insurance companies require that enough cash value be left unsecured in order to cover the first year interest, for example.

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