In this post, I’ll be explaining the The Double Play from another perspective. I’m utilizing the analogy of a Magic Checking Account. This analogy treats the Life Insurance Cash Value as if it were a Checking Account balance. I hope this simple analogy helps people more easily understand the money flows. Using the term: “Life Insurance Cash Value” adds complexity. I’m doing this because many people incorrectly assume that they are borrowing their own money. Policy Loans are loans from the insurance company that are secured by the Life Insurance Cash Value. The Life Insurance Cash Value is simply the collateral.
Introduction
It’s important to understand that a Magic Checking Account allows your money to work in two places at one time. The balance in your Magic Checking Account earns significantly higher interest. Checks that you write against that balance can be used for investments such as real estate.
Because I’m utilizing the analogy of a Magic Checking Account, we take away the complexity of the Life Insurance aspect. Many people do not understand how Life Insurance works or what the Cash Value of a policy really represents. I’m sure that most people can get their arms around a bank account and simply borrowing money.
If you need help understanding Life Insurance, check out my “How Does Life Insurance Work?” e-book
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 understand how a real checking account works. I want to show you why it is not the best place to store your money. Then we are going to take a look at the Magic Checking Account. I’m going to show why real estate investors can use it just like a checking account. This will powerfully accelerate their wealth building. And then finally, I will tie it all together. I will explain 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 out of the account.
It’s important to realize that people keep their money in a checking account is because the funds are liquid. That means when you have money between real estate deals, you want to be ready for the next deal. Even when you are saving up to invest in real estate deals, it’s important to keep your money liquid.
One thing you should know is that deposits are really loans to the bank. They are required to pay you back on demand. They pay you a meager rate of interest, if anything at all. But its important to realize that the bank uses your deposits to make loans at a much higher interest rate. They profit from the interest rate arbitrage they create. They pay low rates on deposits but loan at much higher rates. And even worse, what little, if any, interest you earn is taxed at ordinary income tax rates.
Wouldn’t it be nice to turn things around? That is, put your money into a high interest account and borrow against it at low rates? What if you were the bank?
This is what a Magic Checking Account allows you to do.
The Beauty of a Magic Checking Account
The Cash in a Magic Checking Account (Life Insurance Cash Value) earns an attractive rate of interest. Rates range between 5% and 8% historically. 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. 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’s take a look at the numbers if you were to use that check for investment purposes. It’s important to realize that when investors use leverage for investments in the business world, the business case must make sense. That means that the profit is enough to offset the additional risk.
Does the Investment Make Sense?
Investment returns need to be high enough to account for the risk. And even when you are using your own money, you need to balance risk with return. It’s likely that you have a choice between several different investment options. Which one will you pick? You’ll want to pick the one that will maximize your earning potential with the least amount of risk.[1] I want to make it clear that, as an investor, any investment must be the best thing that you could be doing with your money. That means your investment must earn enough to cover the interest and still make a reasonable risk-adjusted profit.
It’s important to point out that any rational person should strive to make sure that they create an arbitrage. Arbitrage is the difference between what they expect to make and their cost of capital. That means that the investment return needs to cover the cost of capital and still leave a profit.
Leverage Life Insurance Cash Value – The Magic Checking Account
Let’s take a look at an example. Assume we have $100,000 in our Magic Checking Account. Let’s also assume that both our Magic Checking Account and our line of credit are at 6% interest. We are also presuming that we have an opportunity to make a private money loan 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 never truly leaves the account, the $100,000 balance in the account will still earn $6,000 of interest on the loan.
12 months later, the investor pays back the loan and interest. The $110,000 wipes out the credit line and increases the Magic Checking Account balance by $4000. But even better, it’s important to realize that the investment interest is tax-deductible. That means that we’ve created a new arbitrage. The spread between the investment return and the “net” cost on the credit line becomes larger.
Life Insurance Cash Value as a Magic Checking Account
So what does all of this have to do with Life Insurance? I have a point. This is just an analogy, but it’s important to realize that Life Insurance Cash Value works the same. A maximum over-funded Life Insurance Policy 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%. Rest assured, the combined returns are high enough to offset the fees in the policy over time. Compounding interest is a powerful force!
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.
Life Insurance Policy Design For The Win
This Table shows what the same example looks like when we account for the fees. So if you look back at The Double Play example above, you can see that the math still works. The policy owner achieves a higher rate of growth even with the fees and expenses of the policy. It’s important to know that the factors that will impact the effectiveness of The Double Play are the Policy Design and the arbitrage on the outside investment.
It is important to understand that a poorly-designed policy will have fees greater than 15% . You will have less to leverage because more premium is used to cover the fees. It will thus take much longer to catch up to where you would be with a properly-designed policy. You might even have been better off had you simply taken your money and invested it directly. In The Double Play, we achieve a higher rate of growth, but it takes longer to catch up because we have to make up for the fees and expenses. 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 this article was to explain The Double Play through an analogy. There is no such thing as a Magic Checking Account. I just wanted to simply take a look at The Double Play from a different perspective. Oftentimes, the life insurance is a confusing factor.
Notes:
[1] Highest risk-adjusted rate of return.
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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.
