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Policy Loan Options: Understanding Fixed, Variable, and Indexed Loans

The purpose of this article is to explain the various policy loan options and, in the context of The Double Play, show how to utilize each type of loan best.

In a recent blog, I described the Three Key Success Factors for The Double Play.  Number two on that list was accessing the cash value in a tax advantaged manner. More specifically, I stated that you should use a cash value line of credit when you access the cash value for The Double Play. When you’re doing The Double Play you need the tax deduction because it helps the business case by reducing your taxable income.[1]

What I want to do in this post is to cover all of the different policy loan options. I’ll also discuss the applications for those loan options. I will be addressing Fixed Loans, Variable Loans, and Indexed Loans. I’ll also cover the use of a Cash Value Line of Credit briefly.

A Little Background

Before I get started, I want to cover the Life Insurance Statutes regarding policy loans. The State Laws mandating policy loans make The Double Play possible. It is important to realize that all 50 states have insurance statutes that govern insurance companies in those states. The following extract covers the section on policy loans for Florida.

While this is specific to Florida, all 50 states have language in their statutes addressing policy loans. There is a lot of legalese here, but I’ve blocked out the important language. The key takeaway is that insurance company’s must make loans to the policy owner secured by the cash value of the life insurance policy.

It doesn’t say that you are borrowing your own money. It says that the insurance company must loan money to the Policy Owner, with the cash value serving as the collateral.

Number (2) at the bottom is just as important. Number (2) states that if the policy owner does not pay the interest on the policy loan, then the insurance company is to advance the policy owner the money to pay the interest, and just tack it onto the loan balance. These two things are a reason I think Life Insurance is one of the coolest financial products.

So let’s take a look at the different policy loan options…

Fixed Loans  

Fixed loans should never be used for The Double Play. While a fixed loan may sound attractive, the important thing that you need to know is that the insurance company moves the cash value securing the loan into their Fixed Interest Crediting account. This removes a key advantage of The Double Play. It eliminates any opportunity for interest rate arbitrage.

To make it even worse, most companies charge a penalty for taking a fixed loan during the first 10 years. For example, if the loan interest rate is 4%, the cash value should be earning 4% too. But during the first 10 years, the 1% penalty would result in only 3% interest crediting.

A fixed loan is known as a also known as a Wash Loan. For all practical purposes, your loan looks like and feels  a lot like a distribution from your life insurance policy. You’re getting access to the cash and the loan balance exactly offsets the loan amount and interest.

Applications  for Fixed Loans

So, when would you want to use a fixed policy loan? Definitely not for The Double Play!

A wash loan might be attractive to a policy-owner with a low risk tolerance. When used in a life insurance retirement plan, the risk of earning no return while racking up interest is a real possibility. A wash loan removes that risk.

In addition, periods of high inflation could be a time when you prefer a fixed loan. It might be more difficult for the interest crediting to exceed the fixed interest rate that is being offered.

Variable Loans  

Variable loan rates are linked to the Moody’s corporate bond yield. The beautiful thing about a variable loan is that your collateral (cash value) stays in the interest-crediting strategies that you’ve selected. So unlike the Fixed Loan option where the cash value securing the loan is moved into the Fixed Interest Crediting account, the cash value remains exposed to higher potential returns.

Variable loans pose a unique risk with Indexed Universal Life (IUL) policies. The risk with an IUL is that you could have a negative interest rate arbitrage. This happens when the cash value securing the loan earns less than the loan interest rate. When this happens, the cash value doesn’t grow by enough to offset the loan balance. That means there is a risk that the cash value earns nothing even while the loan interest is tacked onto the loan balance.

Understanding the Risk 

The only time that a negative interest rate arbitrage really matters, is when you are taking loans for retirement income. This risk should not concern you with The Double Play. When you are doing The Double Play, you are paying the interest from out of pocket. Paying for the use of money is a cost of doing business. While there may be short term volatility of the interest crediting, it will smooth out over the long run.

It’s important to remember that the arbitrage is on the outside of the policy, not on the inside! You create arbitrage by making sure that your investment returns exceed your cost of money!

The Liquidity Premium 

While it may appear that Interest Rate arbitrage is unique to IUL, Whole Life policies also have positive interest rate arbitrage. Keep in mind that the assets of the insurance company are invested in the debt markets[2] and are earning a “debt market rate of return”.

Since Insurance Companies have long planning horizons, they can capture what I call “The Liquidity Premium“. The Liquidity Premium is the return that an investor can capture if they can lock up their money for a long time (i.e. No liquidity).[3] The Liquidity Premium creates an opportunity for a positive interest rate arbitrage even on a Whole Life policy.

Applications for Variable Loans

Variable loans are ideal for both The Double Play and for Life Insurance Retirement Plans (LIRP). I’ll address both below:

The Double Play 

The Variable Loan is best for The Double Play because the Cash Value remains in your chosen interest-crediting accounts. As a result, the Cash Value has the opportunity for the best possible growth. And again, even though there may be variability in returns each year, an IUL should still earn more than a Whole Life over time.[4]

This means that you have the potential for high interest-crediting on your cash value AND the ability to put that money to work in two places at one time.

Life Insurance Retirement Plan (LIRP) 

Use a Variable Loan for retirement income. Because the cash value has the best potential for growth, there is the best potential for interest rate arbitrage. The arbitrage creates more cash value that can produce more potential income.

The goal of a LIRP is Tax-free Income. You do not pay taxes on loan proceeds. You also do not pay interest on LIRP policy loans!

Since the cash value never leaves the policy[5], the cash value that’s securing those loans grows and fully covers those loans.  It’s important to remember that you don’t have to pay the interest. The insurance company loans you the money to pay themselves the interest on the loan.

I want you to think about this simple example carefully: If you have $1,000,000 of cash value growing at 5% per year, you will have $1,050,000 at the end of the year. If you borrowed $1,000,000 at 5% at the beginning of the year, your loan balance would be $1,050,000 at the end of the year too. The cash value exactly offsets the loan balance in this example.[6]

Indexed Loans 

Indexed loans are unique to indexed universal life. They are sort of a hybrid between Fixed and Variable loans. An Indexed Loan offers a fixed rate that will never change and your cash value is moved to a special interest crediting account.

When would you use an Indexed Loan? Simple. Use the Indexed Loan any time the rate on the indexed loan is lower than the Variable Loan interest rate.

Cash Value Line of Credit 

A Cash Value Line of Credit (CVLOC) is not a “Policy Loan” per se. But, since policy loans are “Personal Loans”,  the interest is not tax-deductible, it is best to use a cash value line of credit when leveraging the cash value to invest in real estate.

The interest on a CVLOC will be considered a business loan if proceeds are used for investment purpose. If you are investing through an LLC or Corporation, the business should be the borrower. The policy owner will give the lender an assignment of collateral as security. Since the loans are 100% secured, the rates are usually at Prime or even lower. [7]

Exception 

However, the one real estate application that works great with a variable policy loan is when you are using the cash value to make a down payment on a property. Many lenders will not offer a loan if they know that you are financing the down payment. Lenders like to see you have a little skin in the game.

Since life insurance is an acceptable source of funds for a down payment, this is one case where you might forego the opportunity for tax-deductible interest in exchange for the infinite rate of return you will achieve on your investment by using 100% financing. Achieving an infinite ROI is the holy grail of real estate investing.[8] 

Conclusion 

The goal of this article was to explain the different policy loan options that are available on life insurance policies. I covered Fixed, Indexed, and Variable loans and how you would use each one in your Real Estate ventures. And, since it is an integral part of The Double Play, I included a cash value line of credit in the analysis.


[1] With the recent increase in inflation and interest rates, commercial loans are now considerably higher than policy loans at the moment. While a cash value line of credit (CV-LOC) may not be the best option right now, it’s important to remember that a life insurance policy is a long term commitment. Things will turnaround again.

[2] Life Insurance Company reserves typically hold US Treasuries, Corporate Bonds, Mortgages from banks, Preferred Stocks and other secured investments.

[3] Think of a bank CD. The longer you lock up your money, the higher the rate that is offered.

[4] To learn why an IUL should earn more over time, check out my other articles on IUL. (Click Here)

[5] Remember: A policy loan is SECURED by the cash value. No cash value leaves the policy.

[6] This is a simplistic example. I did not include the policy charges. The policy charges in a properly-designed policy should be less than 0.25% of the cash value at retirement.

[7] Learn more here.

[8] Learn more here.

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