Guest Article – David Lewis on IBC
I get lots of emails from subscribers – but no one emails me more than David Lewis, a “rogue agent” based a few hours up the road from me outside of Raleigh. Over the years, I’ve come to appreciate David’s creative but technical approach to selling life insurance. He brands under Monegenix and writes his own blog. He shot me a note after seeing the recent article on Infinite Banking with some comments that were in-depth enough that I asked him if he’d be willing to write a guest post on TLPR. He graciously agreed. The remainder of this article is written exclusively by David.
Infinite Banking And Policy Loans: Panacea or Problem?
When my wife and I bought our current home, the Fed Funds rate was 0.65%, and mortgage rates were 3.25%. Then, the Fed Funds effective rate collapsed to 0.08%, but mortgage rates went higher—much higher—to 4.03% for FHA loans and, on average, higher for non-FHA loans. Today, FHA rates hover around 7%-8%, and even non-FHA rates hover between 5% and 8%, and the Fed rate is finally starting to catch up. There are some interesting implications in that alone, but the rise in interest rates across the board gave fuel to Infinite Banking practitioners who were already hyping policy loans to the moon and back as a panacea against the backdrop of a world run by and for a cabal of evil “banksters”. Why pay them all that interest when you can pay yourself instead?
The premise underlying Infinite Banking, and all other similar ideas, is that you finance everything you buy, either explicitly or implicitly. You either pay someone else interest on a loan of some sort, or you lose interest or capital gains (or both) on your savings by paying cash. As one New York Times best-selling author and heavy promoter of the idea puts it, policy loans are a “better than debt free” way to make major expenses. A provocative statement for sure, but is it true?
Let’s find out.
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When Does It Make Sense To Borrow Money?
The decision to take a policy loan shouldn’t be too difficult to figure out. Basically, a policyholder borrows money when that’s the lowest cost option to pay for something, when it’s the most profitable way to do it without taking undue risk, or when a conventional loan doesn’t make sense for some other reason. A lot of folks still believe that paying cash is the lowest-cost option, but that would only be true if the opportunity cost was zero. When does that ever happen? In reality, paying cash means either delaying a purchase, cashing out investments and losing future interest or capital gains on that money, or both. That is the cost a policyholder compares against paying interest on a loan.
If a policyholder is simply comparing rates, then he should calculate a hurdle rate to see if the loan makes sense. Let’s assume the current dividend rate for the policy is 5%, the policy loan rate is 3% with a 1% margin, and the insurer practices direct recognition.
Adjusting for the margin, the net cost of the policy loan could be calculated as roughly 3%, but this only factors in the direct cost of the loan. If all you’re doing is simple rate comparisons, then a 3% APR is a clear winner in the majority of cases. But, with policy loans, there are also soft costs resulting from a reduction in the dividend rate (and the corresponding dividend credits) under direct recognition, since the dividend rate on the collateral held for the loan will be reduced to match the policy loan rate. Once these costs are added back in, the true cost of the loan is more like 8%. So, the loan should be repaid at 8% or higher. If the policyholder can’t get a conventional loan for less than 8%, then this is a great deal. Alternatively, if the lost interest on cash is greater than the policy loan, or if delaying a cash purchase would cost more than financing, then the loan makes sense (economically, at least). Otherwise, it may not make a lot of sense unless the policyholder simply wouldn’t qualify for a loan elsewhere, he needs more control over the repayment than a conventional loan would allow, or he needs to maintain a cash position for some reason.
What about non-direct recognition? On paper, the hurdle rate will be lower than for many direct recognition policies as long as there aren’t too many other policyholders taking loans out at once. The infinite banking diehards love the fact that non-direct recognition policies don’t change the published dividend rate on loaned amounts. It certainly does make the hurdle rate look more favorable, but I’d argue that the true costs in the long-term are similar, if not the same, as direct recognition. If enough policyholders start borrowing, the insurer will have to lower dividend rates on all non-direct recognition policies to account for the very real cost incurred there. Or, the insurer will have to be more conservative in raising its DIR relative to companies practicing direct recognition. So, the risk and expense of non-direct recognition is there, but maybe not yet realized. Either way, non-direct recognition policyholders would probably benefit themselves by just assuming a higher hurdle rate, regardless of what it looks like on paper.
Assuming it makes sense to borrow money from the insurance company, how does that play out in real life for the policyholder?
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A Simple Example Of Using Policy Loans To Save Money On Premium Charges
About a year after I sold my wife (then fiancé) a policy, she came to me and asked why she shouldn’t just finance her premium payment. After all, paying premiums monthly came saddled with a finance charge that was higher than the policy loan rate. I didn’t have a good answer, other than I didn’t think it would work. The more she insisted it would, the more I insisted that the insurance company would never allow policyholders to get leverage over on them like that.
And, like all the other husbands that came before me, I was wrong.
I started playing around with this idea on all of our policies, then ran illustrations for clients, to make sure this wasn’t a fluke. For one of the policies I looked at, the monthly premium was 1,005.35 and carried a finance charge equivalent to 9.5% APR. The policy loan rate, however, was 5%. Paying via a premium loan would essentially convert the policy to annual payment mode, and eliminate the finance charge, leaving a total premium due of $11,555.71. So, here’s how the premium loan looked (the actual date of the policy loan/repayments is incorrect, but otherwise the values reflect the actual charges for the policy):
In the “infinite banking” way of thinking, you would finance that premium at a rate equal to or higher than the rate being charged by an outside lender, so that’s what we did. In this case, it meant paying the premium loan back at the same rate the insurance company would have charged over 12 months and then pocketing the difference, putting the savings into a savings account or buying more paid-up additions with it. Why not just switch to annual and skip the premium loan? It’s a fine option if you have the money already, but if you’re paying premiums out of current income, that’s not an option. Plus, waiting a year to save up the full annual premium still carries an implied cost—it’s 12 months you’re not not paying premiums and not having a policy. Even if you already had the money sitting in a savings account somewhere, there’s an opportunity cost associated with using that already-accumulated savings versus “pouring” that savings into the PUA rider in addition to making regular monthly premiums or premium loan repayments. Doing anything other than paying premiums out of current income carries an implied cost. From there, it’s merely a matter of how much it costs, and how you want to pay for it. This is the core idea behind “infinite banking”. You cannot escape finance charges. You can only choose how you want to pay for them.
For this policy, we chose to finance them directly using a premium loan of $11,555.71. We then repaid the premium loan with an amount equal to the monthly premium the insurer would charge (including the finance charge). The result is a savings of $207.04. This works partially because of the way the insurance company charges and bills interest. Policy loans are interest-only lines of credit where interest is charged on only the outstanding principal balance. The insurer charges a daily rate, the interest accrues daily, and then the insurer bills the interest to the policyholder at the end of the year. Meanwhile, policyholders are allowed to pay down the principal balance during the year before paying any interest. Over time, this can have a significant impact on the total interest paid. It’s true that if policyholders don’t pay the interest, it gets added to the loan balance and compounds against the policyholder’s cash value. But, that blade cuts the other way, too… if the policyholder is willing to stick to a repayment schedule.
A savings of $207.04 may not sound like much, but this is also a 12 month loan. Where policy loans get really exciting is when they’re used for large capital expenditures.
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Financing A House
Some people might think it’s crazy to finance a house using a life insurance policy, but… have you seen mortgage rates lately? This is the exact thought that went through a client’s head recently. The policy loan rate on his policy is 5%. Mortgage rates are now over 7%. Let’s do the math. On a $1.5 million home, with a 10% down payment, the client would normally be financing $1,350,000 at 7.250%. On a 30 year fixed-rate mortgage, the total interest comes to $1.965 million(ish). The total cost of the loan is $3.315 million(ish). Here is the breakdown from Bankrate’s mortgage calculator for the first 12 months, followed by the 30-year summary:
Here’s the same loan using a policy loan instead of a mortgage. I assumed the same 10% “down payment” which produces the same monthly payment of $9,209. As you can see, policy loans are very different from mortgage loans. The client pays down the principal of the loan before paying interest:
At the end of 12 months, the interest is added to the loan balance, but the policyholder repeats the cycle. Total payments for the year are higher than the total cost of the annual accumulated interest, preventing the interest from compounding. This has a dramatic impact later on (the following summary still assumes monthly payments, but only shows end-of-year totals):
The total amount of interest paid to the life insurance company amounts to just $708,805.57, a total savings of $1.256 million over the conventional mortgage. And, the entire $1.256 million can be put into the client’s savings account, some other investment, or… reinvested back into the life insurance policy through the paid-up additions rider. Is that worth it to the client? You bet it is. If the client canceled his policy and paid cash for the house, he’d lose all the equity in his policy, lose the future growth of his policy, the death benefit, and all of his equity would be tied up in his house. Using his policy, the cash values continue to compound (direct recognition adjustments notwithstanding). At the end of it, he has the net growth on that cash value, plus the equity in his house, plus the restored equity in his policy from repaying the loan, the ability to borrow more money without going to his mortgage lender, and… a death benefit.
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What Could Possibly Go Wrong?
When the client is paying what he’s “supposed” to pay, everything works fine. But, now that rates are rising on conventional mortgages, the currently low rates on policy loans are looking very attractive compared to the alternatives. What if the policyholder decides he deserves a 2.25% mortgage rate, and so only repays his policy loan at a 2.25% repayment rate? He is, after all, his own banker, right? Maybe he’s not ready for this new rising rate environment. Here’s what happens to him:
Uh oh. Over the next 30 years, his “mortgage” loan grows, and he’s left with $1.625 million in policy debt:
But, of course, that’s not the worst thing that can happen. Policy loan rates are low today, but what happens if they are pushed higher? If the insurer raises loan rates, and the policyholder only pays enough to cover the increase, the problem gets worse. In this example, I assume policy loan rates increase by 50bp each year starting in the 3rd year of the loan and continue rising for the next 5 years, going from 5% at the start of the loan to 8% in year 7:
Perhaps this is why Nash emphasized being an “honest banker” by paying market rates (or above market rates) instead of the insurer’s loan rate. But, how many agents truly understand this idea and weave it into the sale? And, how many clients truly buy into the idea that they are their own banker vs just seeing life insurance policy loans as a way to get leverage over on the insurance company or worse… life insurance as some magical product that somehow defies the laws of finance? Are clients committed to the concept, or are they merely chasing low loan rates in the same way they were chasing high crediting rates for the last couple of decades? If or when policy loan rates rise, how many of these sales, which were predicated on low or falling interest rates and illustrated arbitrage, will unravel?
Only time will tell.
By the way, rising loan rates aren’t just a problem for infinite banking folks. This is a problem for anyone illustrating decades of retirement income from life insurance policies using the policy loan feature. In the above examples, the policyholder is paying at least something back to the policy. What if the policyholder pays nothing back? This scenario shows a 45 year old male, non-smoker, paying premiums from age 45 to 65 into an IUL, then drawing income from the policy using withdrawals and switching to policy loans after his basis is recovered. I included various crediting rates to show the effect it has on total income potential, as well as the loan balance and associated loan interest expense over time, using a traditional policy loan at the maximum illustrated rate (8%), reflecting hypothetically higher interest rates in the future:
Only one scenario seems to work out OK. The rest of them fail at an arbitrary future age, which may or may not correspond with the client’s actual death. That should terrify your clients and, frankly, you too.
We could always complicate matters by including an indexed loan, or assuming changing expenses over time, but I think the assumption we can make here is the more complexity we introduce, the riskier this policy gets and we might see potentially worse outcomes. One of the things that makes life insurance work so well is it allows the policyholder to plan for the worst, but hope for the best. Today, agents seem to have forgotten that basic idea, and so have policyholders. We are using life insurance to increase financial risk instead of decreasing it. If we really wanted to be conservative, the above illustration would work fine under the guaranteed assumptions of the policy, and potentially get better at higher crediting rates.
This illustration shows just how risky things can become. Changing the crediting rate by a mere 1% dramatically changes income potential from the policy. I’m sure no one would be unhappy about income running out to age 121. But, what if crediting rates amount to 5% instead of 6%? How do you know your client will die before age 90? What will happen if your client lives to age 91 or 92? What if crediting rates fall to the 4% or 3.25% rate? Or, what if rates start out at 6%, but fall to the guaranteed rate in retirement? Don’t think it can happen? Have we already forgotten what happened to Ohio National? Or, to take a long-forgotten example, Aviva? Companies, can and do change. That logically means income scenarios can change, too. Sure, we could lower income from the policy to try and save it, but how does that really put the client into a better position if they desperately need the income or were depending on it because that’s what was illustrated when the policy was sold to them?
As long as it works, fine. But, if things turn sour, what will the policyholder do? The insurance agent should already have an answer for them, now.
