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Why You Shouldn’t Use A Policy Loan If You Leverage Your Cash Value to Invest in Real Estate

Introduction

Are you using your life insurance policy’s cash value to invest in real estate? Are you using a policy loan from the insurance company? If so, you need to read this post. Don’t use a policy loan when you leverage the Cash Value of an Infinite Banking policy for investing in real estate!

One of the great things about using The Double Play for Real Estate Investing is that the interest expense reduces the taxable income on your investing activities. So whenever I hear an agent talk about using a policy loan to access the cash value, it is clear to me that the agent has probably never actually done this themselves. If they had, they should have realized that the interest is not tax-deductible.

The goal of this post is to illustrate the significant Improvement in The Double Play performance by utilizing a tax-deductible cash value line of credit instead of a regular policy loan.

Overview

The goal of this article is to illustrate the significant improvement in The Double Play performance by utilizing a tax-deductible cash value line of credit instead of a policy loan. Policy loan interest is not tax-deductible.

There are three key success factors when implementing The Double Play: putting your money to work in two places at one time by leveraging the cash value of a maximum overfunded life insurance policy. The first, and probably most important success factor is the policy design. You need to have a properly-designed, maximum over-funded life insurance policy in order to minimize the policy charges. If you are putting your money to work in two places at one time, you want as much money working in two places as is possible, right? Policy design was discussed here.

The second most important success factor is using a business or commercial loan secured by the cash value. This is the topic of this paper. The interest expense reduces the taxable income from your real estate investing activities. If you are giving less money to the IRS, you are keeping more for yourself. Keep reading to see the numbers!

The final key success factor is the choice of policy type: Whole Life or Indexed Universal Life. You can learn more about why I believe an Indexed Universal Life policy will outperform a Whole Life policy here. Compounding interest is a very powerful force. The ability of the cash value of an Indexed Universal Life to capture some of the Equity Premium means that the long term growth will be greater.

Cash Value Line of Credit

I won’t beat around the bush: the best way to access the cash value of your life insurance policy for investing in real estate is to use a cash value line of credit from a third-party bank. If the loan is used for business purposes, then the interest is tax-deductible. 

Your business can apply for a business line of credit and you personally can pledge the cash value of the life insurance policy as collateral. The life insurance policy doesn’t need to be in the business. It’s more like a personal guarantee. If you default on the loan, then the lender can come after the collateral securing the loan.

Since the benefit of tax-deductible interest may not be immediately obvious, I’m going to show a couple of examples to highlight the benefit. But before that, I want to show you a baseline example of what it looks like when you don’t leverage cash value at all.

Each example will be based on an investment of $100,000 that will generate 10% income. I’m further assuming that the tax rate is 40%. In the case of the life insurance, I am going to assume that the interest rate on the policy loan and the cash value line of credit are both 5%. And I am assuming that the dividend rate of the life insurance policy is 6%. That is a 6 percent return on the cash value proportion of the policy.

So the first example we will look at is where we are investing with 100% cash and then we will compare that to the situation where we are investing with a policy loan. You’ll find that the policy loan is better than using your own cash but then will compare it to using a cash value line of credit where the interest is tax-deductible.

No Life Insurance

For the baseline scenario, we are investing $100,000 into an investment that is generating $10,000 of income each year. Income taxes on $10,000 at a 40% tax rate will be $4,000 leaving you with $6,000 of net profit. That works out to be a 6% net return on investment.

 Leverage Using a Policy Loan 

In this example, I am assuming that we have a life insurance policy with $100,000 of cash value that is earning a 6% dividend each year or $6,000. If the policy owner gets a loan for $100,000 and uses that loan to make the same investment as in the earlier example, the owner will make the same $10,000 of income during the year.

Because the interest on the policy loan is not tax-deductible, the policy owner will have to pay $4,000 of income tax on all of that income leaving $6,000. At this point, the policy owner also needs to pay the interest on the policy loan. So after we subtract the $5,000 of loan interest from the remaining net profit, we are left with $1,000. During that year, the cash value of the life insurance policy was credited with a $6,000 dividend so the overall net return is $7,000 or 7%.

When we compare this example to simply using our own cash to invest, you can see that we made 1% more overall. 

Now let’s take a look at a situation where we are using a cash value line of credit and the interest is tax-deductible.

Leverage Using a CVLOC

Just as in the previous example, we assume that we have $100,000 of cash value. But this time we are accessing the cash value by utilizing a cash value line of credit. And just as in the earlier two examples, we will finish up the year with $10,000 of income. But this time we can deduct the interest on the line of credit. 

The loan interest on our $100,000 line of credit is $5,000. This is a business expense and when you subtract it from our gross income, we end up with $5,000 of net income. In our 40% tax bracket, the tax obligation will be $2,000 on that $5,000 of net income leaving us with $3,000 of net income. If you are keeping score, that is 3-times the income in the previous example!

This $3,000 is then added to the $6,000 dividend that was credited to the cash value for an overall net gain of $9,000 or 9-percent.

Analysis

Using a cash value line of credit instead of a regular policy loan resulted in three times the net income from our investing activities. The dividend was unchanged in both scenarios. Both scenarios resulted in the policy owner successfully putting their money to work in two places at one time, but the policy owner who utilized the cash value line of credit was much better off.

So one of the problems with leveraging cash value is that while you can put your money to work in two places at one time and earn a higher rate of return, the problem is that life insurance has costs. As I’ve explained in other articles, the cash value of a properly designed and maximum over-funded life insurance policy should be about 85% of the premium.[1] About 15% of the first year premium goes toward policy charges and expenses. So while we are putting our money to work in two places at one time and earning a higher rate of return, we are starting with a handicap. 

Not only do we have to make up that 15% loss, but we also have to catch up to where we would have been had we simply invested without leveraging the life insurance. That is the true opportunity cost of The Double Play: with all else remaining equal, is leveraging the cash value of life insurance to invest in real estate better than just investing in real estate?

If you understand the power of compounding interest, you know that both ways of accessing the cash value will eventually work out in favor of The Double Play. But if you are more of a visual learner, I’ve created this graph for you:

Note: This is for illustration purposes only. My goal here is to show the power of compounding interest. I am not factoring in the cost of insurance. Nonetheless, we can see that the cash value of a properly-designed, maximum over-funded life insurance policy being leveraged with a cash value line of credit would catch up to the baseline scenario shortly after the 6th policy year.

However, when the cash value of that properly-designed, maximum over-funded policy is leveraged using a regular policy loan, the cash value still hasn’t caught up to the baseline scenario by the 15th year. 

Please keep in mind that the numbers in this chart are looking at the cash value of the first Year’s premium in isolation. In the real world there would be new premium being paid into the policy every year. I wanted you to see that the crossover point where The Double Play beats investing directly in real estate can occur relatively quickly. 

The second year premium is going to have the same expenses as the first year. So while we took a 3% step forward in erasing the 15% “loss”, there is still a long way to go. In year two we get more cash value into the policy, but we take another big step backward.

Both the “Real Estate Only” and The Double Play examples were funded with $40,000 each year for 7 years. The “Green” Minimum Non-MEC Design is the curve assuming a properly-designed policy with approximately 85% cash value to premium. In this example we see that The Double Play surpasses the “Real Estate Only” scenario around the 12th year of the policy (Age 59).

Note: The Blue line on this graph denotes a poorly-designed over-funded policy with higher fees that results in only 65% cash value to premium. It does not denote the regular policy loan scenario. I borrowed this graph from another article.

I want you to use your imagination to picture how a poorly-designed policy using a regular policy loan would compete with the alternative of investing directly in real estate with no life insurance. Where would the crossover occur? 

Conclusion

It is important to understand that The Double Play is a long-term wealth accumulation strategy. But just because it is a “long-term” strategy doesn’t mean we have to purposely make it a long(er) term strategy by not leveraging the cash value to take advantage of the tax deduction you can get with a cash value line of credit. The slight difference in return due to utilizing the cash value line of credit may not be immediately obvious, but when you understand the power of compounding interest and time you’ll realize that the difference is substantial.

The problem is only further exacerbated when using a policy loan in conjunction with a poorly-designed policy as the last graph shows.

Optimizing the way you do your business will make a big difference in your wealth accumulation.


[1]

Assuming a Preferred, Non-tobacco rating. 

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