What if you could get all the money that you wanted at 4% and knew that you could turn around and invest it at 5%. How much money would you want?
All of it, right?
Or, if we look at it another way, what if you could get a loan for a million dollars from the bank that you could use it to fund a retirement plan? That would be pretty awesome, right? This page will cover why banks want to do just that. Its called Premium Finance.
This is a bit outside the realm of The Double Play, but the same concepts apply and it may be an attractive solution for many people who have not started investing in real estate and would prefer to take a much easier approach. Real Estate Investing is tough and it takes a lot of time to analyze deals, make offers, negotiate, and manage the property.
Believe it or not, banks want to loan you a million dollars, or more, to purchase High cash value life insurance policies like indexed universal life, for example. So keep reading. I’m going to explain what premium finance is and why banks WANT to loan you money to purchase life insurance… if you can qualify…
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What is Premium Financing?
I’m a bit of a financial nerd. So things like compounding interest and interest rate arbitrage fascinate me. Premium Financing is the Mack Daddy of interest rate arbitrage.
If you have been the pages and blogs on this site, you know about the power of a maximum over-funded life insurance policy. You can see just how beautiful it would be if a bank was willing to loan you the money to start a policy.
Life insurance is the perfect collateral for a loan. It is principal-protected and the bank gets an assignment of collateral against the policy’s cash value. If you default on the loan, their name is already on the policy. It is one of the most secure ways of lending for the bank.
The goal of this website is to demystify life insurance and to give you the tools you need to know — without talking to an agent — to get the most efficiently-designed policy to maximize your wealth accumulation through your utilization of 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.
With Premium Financing, we are going to flip the double play on its head and look at using leverage to purchase the life insurance instead of leveraging the cash value of your own policy.
How Does Premium Financing Work?
Banks will happily loan you money to pay for life insurance premium in a maximum over-funded, high cash value policy, knowing that the cash value of the policy is the collateral for the loan that they make to you. Cash value is the perfect collateral for a loan. The bank gets an assignment of collateral against the policies cash value, so they don’t need to worry about foreclosing on the loan.
The amount of Premium that you can put into a policy is limited only by how much interest you can afford to pay and by how much death benefit you need. There has to be a legitimate purpose for the life insurance death benefit. remember, the primary reason for purchasing life insurance is the death benefit protection.
But for an interest rate arbitrage nerd like me, however, it is all about the beauty of Simple versus Compounding interest. If, for example, I can borrow $1,000,000 at 5% simple interest, I am going to pay $50,000 a year until I pay back the loan.
It is important to point out that these are interest-only loans. There is no payback of principal over time as in an amortizing loan like your mortgage.
So while I am happily paying the $50,000 a year in interest, approximately $850,000 of the $1 million is growing and earning interest at a compounding rate.
Over time, the cash value of the policy could be many times the amount of the loan principal. Compounding interest is the most powerful force in the universe.
Pros and Cons of Premium Financing
The beauty of Premium Financing is that you can put the bank’s money to work to build wealth and purchase large amounts of death benefit protection.
The catch is that you need to have income and net worth that are high enough to justify the amount of insurance and to afford the interest payments on the loan. If you are borrowing a million dollars at 5% interest, for example, your annual interest expense will be $50,000.
Leverage also increases risk.
Historically, Premium Finance programs have only been made available to people with a five to ten million dollar net worth or more. However, in recent years, programs have been made available for a class of individuals known as “emerging affluent”.
There are now programs available for individuals with an income as low as $100,000 a year and a net worth of about $500,000 or more.
Another con is that the loans must be 100% secured. This means that if $1 of Premium turns into $0.85 of cash value, then the policy owner must have to have other assets to make up the other 15%. This can be accomplished with a letter of credit or an assignment of collateral. This highlights the need for a properly designed and maximum overfunded life insurance policy.
Life Insurance 101
Premium Financing and The Double Play are advanced life insurance topics. so if you have read this far and you don’t understand what the cash value represents, I have some great tutorial videos that you can go back and watch. If you are familiar with life insurance and have read the Life Insurance 101 eBook, you can skip ahead to the next section.
I recommend that you should go back and watch the Life Insurance 101 video and maybe even the video on Minimum vs Maximum Over-funded Life Insurance Policies. I will leave links to these videos and the description as well as a link to my Life Insurance 101 eBook. Those videos are the foundation that everything else is built upon.
The 60-second explanation is that the cash value of a life insurance policy is essentially the policy owner saving up the death benefit for the insured over the insured’s expected lifetime. The life insurance company is really just covering the gap between this savings and the amount of the death benefit.
So if you are a 45 year old, for example, and you want a policy with a $1 million dollar death benefit, your premium will be such that the savings component will grow and accumulate to reach $1,000,000 by the time you reach your life expectancy, assuming a very worst-case rate of growth assumption. This worst-case interest rate assumption is also known as the “Guaranteed Rate”.
A policy designed like this is a minimally-funded life insurance policy. Now getting back to premium financing, No bank in their right mind would loan you the money to pay the premium for a policy like this when there is very little collateral for their loan. Most of the premium is going towards the cost of insurance and very little of it is going towards the cash value which is the collateral for their loan.
Banks want to loan money to purchase Maximum Over-funded life insurance which is the complete polar opposite of a minimally-funded life insurance policy. In a minimally-funded life insurance policy, the goal is to get as much death benefit for every dollar of Premium being paid. In a maximum over-funded life insurance policy, the goal is to purchase as little death benefit as possible for the money. In a policy designed like this, as much as 85% of the premium goes to the cash value.
Let’s take a look at an Example
In this chart we are comparing the interest expense, the cash value, and the loan amount. This particular design is showing a 5-pay of $100,000 premiums each year for 5 years. The interest rate assumption on the loan is 5%. The cash value is assumed to be growing at 6%. I am not showing any set up fees or origination fees for this example case. I just want you to see the simple numbers.
In a properly-designed and maximum over-funded life insurance policy, the cash value to premium ratio should be about 85%. In this example, you can see that the cash value is just slightly less than the loan amount for each of the first five years. As time goes on and the curve gets steeper, the equity grows at an ever-accelerating rate.
After the fifth year, you can start to see the power of compounding interest. The loan balance remains constant at $500,000. The annual interest expense is barely visible on the graph, but is $25,000 a year. You can see that while your annual expense remains constant at $25,000 per year, the “Equity” in the policy is rapidly and exponentially accumulating.
Less Optimal Designs:
The beauty of Premium financing is when you can get a loan with simple interest payments while the cash value of the policy is earning compounding interest.
There are, however, premium financing arrangements for the Emerging Affluent category where premium financing is allowed as long as the Policy Owner has some skin in the game.
In these designs, the policy owner pays 50% of the premium for 5 years and the financing company finances the other half of that premium for 5 years and then pays the entire premium for the 6th through the 10th years. A program called Kaizen is a very popular example.
One of the “cons” of this design is that since there are no explicit interest payments, these strategies rely on financing the interest payments. The interest is not forgotten, it is just accruing until the loan is closed out–usually after the 15th year. The cash value resulting from YOUR portion of the premium is the collateral for the compounding loan balance that is building up.
The loan in this type of program is closed out after 15 years. That is when the lender gets back all of the loan principal as well as all of the accrued interest.
Compounding interest is great when you are earning it, but not when you are paying it.
This example shows a 10-pay of $100,000 per year. The interest crediting rate assumption is 6% and the loan rate is 5%. The client is making a down payment for half of the premium for the first 5 years from their own funds and borrowing to cover the other half. Then they are borrowing the entire $100,000 premium for years 6 through 10.
While not optimal, these designs do work. You should come out ahead because you are still putting the bank’s money to work for yourself, but they are highly dependent upon the interest crediting rates exceeding the loan rates.
When your loan balance is growing at a compounding rate and your cash value is growing at a compounding rate, you are dependent upon interest rate arbitrage. If the loan rate exceeds the crediting rate, your equity in the policy is at risk. The risk to the borrower is much greater with this design approach.
The interest rate is the primary risk in premium financing. The loan rates are typically based on LIBOR plus a spread. Changes in the interest rate will mainly impact the interest payments on the loan.
People often mention the potential for a negative interest rate arbitrage as a risk. But, keep in mind that as long as we are comparing simple interest versus compounding interest, premium financing will still work even with a negative arbitrage. Again, compounding interest is the most powerful force in the universe. it may take longer for the cash value to surpass the loan balance, but it will eventually surpass.
Negative interest rate arbitrage is a much greater risk in the Kaizen planning approach. Kaizen is only done with Indexed Universal Life because the cash value should earn a premium over the debt market rate of return earned by a whole life policy.
Also, keep in mind that loan rates are a function of the Debt markets: Bonds, Treasuries, etc. So if interest rates rise, it will impact the cash value of the policy in a positive way too because the yields on the life insurance company’s investments will also rise.
IUL vs Whole Life for Premium Financing
It doesn’t matter if you use Whole Life or Indexed Universal Life. The one thing you want to ensure though, is that you use a maximum over-funded policy design. Since the cash value of an Indexed Universal Life policy can capture some of the “Equity-Premium”, an IUL should outperform a Whole Life.
In fact, most of the lenders that I work with prefer to make loans for properly-designed Indexed Universal Life policies. The fact that the cash value will grow at a faster rate reduces the risk for the lender because the cash value is the collateral for their loan.
The fact that lenders prefer to loan money against index universal life, when the cash value is the collateral securing the loan, should dispel the notion that infinite banking and other private banking strategies must be done with whole life.
If the bank trusts their money going into an Indexed Universal Life, you can be sure that it is safe enough for your money as well. Again, just ensure that your policies are designed for maximum cash value.
Go back and watch the videos for “Life Insurance 101” and “Minimum vs Maximum Funded Life Insurance” for the facts and data supporting this assertion.
If it were up to me, I would never close out the loan. I would simply keep on refinancing it every time it comes due. If you look at this chart, you can see that with every passing year the gap between the loan balance and the cash value gets larger. You can take income from the policy when you retire and it will more than cover the loan interest. THAT would be the ideal time to finance the interest expense on the loan.
However, you have the option of taking a Withdrawal of the cash value to close out the loan or transferring the loan balance to a policy loan. The policy loan interest can be paid from outside the policy (to continue the simple vs compounding interest rate arbitrage) or it can be financed like most other policy loans for retirement income.
A Life Insurance Retirement Plan (LIRP) is based on the idea of borrowing to pay the interest on policy loans for retirement income. All of the policy loans plus the borrowed interest on the loans is collateralized by the cash value of the policy. So eventually, in order to take income from your life insurance policy, you must finance the interest on the loan. It is just good financial common sense to delay financing the interest for as long as possible.
Premium Financing is the Mack Daddy of interest rate arbitrage. As long as you have a need for the death benefit and can afford the large interest payments to put large sums of money to work, it is a very powerful tool to build wealth and provide protection for your family, business, or estate.
I have links to the Life Insurance 101 video and eBook in the description as well as the Minimum and Maximum Over-funded Life Insurance Policies video and eBook.
Please join The Double Play community on Facebook where you can connect with like-minded investors who are putting their money to work in two places at one time by leveraging the cash value of a maximum-funded life insurance policy to invest in real estate. The link is in the description.Thanks for watching! Be sure to like and subscribe so that you receive notifications when I post new videos.
View the Recording of the Webinar on Premium Financing.
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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.