In this post, I’ll be explaining the The Double Play from the perspective of a “Magic Checking Account.” I utilize the concept of a Magic Checking Account to simply help people more easily understand the flow of cash by taking away the life insurance element which is a complicating variable.
Since The Double Play involves life insurance, there is often a lot of preconceived bias against life insurance and misunderstanding of where the money is coming from to make the investments. As you read this post, the power of The Double Play for putting your money to work in two places at one time will become easily evident. Because your money can work in two places at one time, you can powerfully accelerate your wealth building.
Introduction
A Magic Checking Account allows your money to work in two places at one time. The balance in your Magic Checking Account earns interest and the checks that you write against that balance can be used for investments such as real estate.
I utilize the concept of a Magic Checking Account to help get the life insurance aspect out of people’s thinking. Many people do not understand how life insurance works or what the cash value of a policy really represents. Most people can get their arms around a bank account and simply borrowing money.
So understand that a Magic Checking Account is not a real thing. I am just using it as a conceptual framework for understanding The Double Play.
The first thing we are going to do is look at a real checking account and why it is not the best place to store your money. Then we are going to take a look at the Magic Checking Account and show why real estate investors can use it to powerfully accelerate their wealth building. And then finally, I will tie it all together by explaining how Life Insurance Cash Value relates to the Magic Checking Account.
The Problem With Real Checking Accounts.
So let us begin by thinking about how a normal checking account works. You put your money into an account with a bank where it earns virtually no interest if any at all. Then when you write a check, the bank transfers your money to the bank of the person who cashes the check.
The reason people like to keep their money in a checking account is because the funds are liquid. When you have a large sum of money in between real estate deals or even that you are saving up to invest in real estate deals, keeping your money liquid and available is critical because you never know when you will need access to it in order to close on a deal.
When you put your money on deposit with a bank, you are essentially loaning your money to the bank. They have to pay you back upon demand. They pay you a meager rate of interest, if anything at all. However, the bank in turn uses that cash to make loans at a much higher interest rate. They profit from the arbitrage they create between the rates that they loan money at and the rates that they pay for the use of the money. What little, if any, interest that is earned is taxed at ordinary income tax rates.
Wouldn’t it be nice to turn the tables and invest your money and earn a high rate of return and then borrow against it at a lower rate to do your own investing? What if you were the bank?
That is what a Magic Checking Account allows you to do.
The Beauty of a Magic Checking Account
In a Magic Checking Account, the cash held on deposit with the bank earns an attractive rate of interest that ranges between 5% and 8%. And what really makes it magical, is that when you write a check, the money never leaves your interest-bearing account. What happens is that the bank keeps an open line of credit with a balance equal to the amount of cash that you have on account.
So when you write a check, the funds are not transferred from your account, but are instead paid from your line of credit. This allows your entire cash balance to continue to earn interest.
Now, of course, since you are using a line of credit when you write a check, the balance is accruing interest. But imagine if this interest was equal to the interest that the bank account was earning.
The balance of the loan would be exactly offset by the growth of the account balance in your Magic Checking Account. For all practical purposes, it would look and feel just like you wrote a real check. The interest that you are paying and the interest that you are earning cancel each other out and the net effect is that it looks like you transferred the money out of your account.
Using a Magic Checking Account for The Double Play
Now let us take a look at the numbers if you were to use that check for investment purposes. When investors use leverage for investments in the business world, the first thing that they have to do is determine whether the investment makes sense.
Even if you are using your own money, you may have a choice between several different investment options. You want to pick the one that will maximize your earning potential with the least amount of risk.[1] As an investor, you have to ask yourself whether any investment is the best thing that you could be doing with your money. Further, if you are utilizing leverage, your investment must earn enough to cover the interest cost and still make a reasonable profit given the risk of the investment.
Why am I stating all this? Because any rational person, borrowing money to invest, wants to make sure that they create an arbitrage between what they expect to make and their cost of capital. Basically, the investment return needs to cancel out the cost of capital and still leave a profit. So when the loan payments are canceled out on the outside of the Magic Checking Account, that means that the balance inside the account should be included in the total investment returns.
So let’s say we have $100,000 in our Magic Checking Account and both our Magic Checking Account and our line of credit are at 6% interest. And let’s further say we want to make a private money loan to a real estate investor for 12 months at 10% interest.
When we write a check to the investor, we are drawing against our credit line secured by the balance in our magic checking account. Since the money is never truly leaving the account, the $100,000 balance in the account will still earn $6,000 of interest during the 12 month period that the loan is outstanding.
At the end of the year, the investor will pay back the $100,000 plus the $10,000 of Interest owed on the note. This pays off the credit line balance. Since the credit line was used for investment purposes, the interest is tax-deductible as a business expense. The interest expense will reduce our gross income to $4,000 of taxable income.
Cash Value as a Magic Checking Account
So what does all of this have to do with Life Insurance? Well, the cash value of life insurance holds all the same properties as our hypothetical Magic Checking Account. The main thing that we need to keep in mind is that the Premiums that you pay into a permanent life insurance policy are subject to the fees and expenses of the policy. So there is not a one-to-one relationship between the premium and the cash value. In a properly designed, maximum over-funded policy design, the cash value to premium ratio should be about 85%
Note: If you don’t understand what the cash value of a policy is, Life Insurance 101 is a perfect overview for you. There is also a YouTube version of this here. I explain maximum over-funded policy designs in this blog post and in this video.
So if you look back at the math in our Double Play example above, you can see that the math still works and the policy owner will still achieve a higher rate of growth even with the fees and expenses of the policy. The factors that will impact the effectiveness of The Double Play are the policy design and the arbitrage on the outside investment.
Policy design impacts how long it will take to catch up to where you would have been had you simply taken your money and invested it directly. In The Double Play, we are achieving a higher rate of growth, but since we have to make up for the fees and expenses, it takes time to catch up. But it will catch up. Compounding interest is a very powerful force.
And as for the arbitrage, that is simply a business decision. If there is not enough arbitrage, don’t do the deal.
Conclusion
So just to summarize, the purpose of the Magic Checking Account example is to simply take a look at The Double Play from a different perspective where we don’t include the life insurance aspect of it as a complicating factor.
Since most people can visualize a checking account, putting the money to work in two places at one time by utilizing a Magic Checking Account sometimes makes the concept a little easier to understand.
Highest risk-adjusted rate of return.
Click here to join out mailing list to receive monthly Financial Tips
Questions? Click the button to schedule a time for us to call you.
No Rendering of Advice: The financial content in this document is provided for your personal education. It is not intended for trading purposes, and cannot substitute for professional financial advice. Always seek the advice of a competent financial advisor with any questions you may have regarding a financial matter. Information in this document is not appropriate for the purposes of making a decision to carry out a transaction or trade nor does it provide any form of advice (investment, tax, or legal) amounting to investment advice, or make any recommendations regarding particular financial instruments, investments, or products.
The sole purpose of life insurance is for the death benefit protection. Any other benefit is ancillary.
