What Is a Life Insurance Loan? – Episode 264

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[00:04] Welcome to the Prosperity Podcast, fresh alternative personal finance talk for independent thinkers who prosper outside of Wall Street. Here’s your host, bestselling author, Kim D.H. Butler. Hello listeners and welcome to the Prosperity Podcast. Today we’re taking a listener question, but this listener question isn’t your typical, hey, I have this amount of money and what should I do with it or what’s going to happen in the marketplace. This listener question is one that is really hard to hear and to swallow, which is why did my advisor or I should say the financial planner I was using lead me down the wrong course. Kim, let’s dive into this question. Yes, yes. I had to laugh at your switch of words because we love to make clear that there

[01:00] are typical financial planners out in the marketplace and they have wrong information sometimes. Really at the heart of this issue and yet I will also readily admit that there are prosperity economics advisors out there, which we like to differentiate from financial planners and they too make mistakes. I mean, we’re human beings. I’ve made mistakes. I’ve led clients down the wrong path. So the real question is why is this happening? But there’s a more specific question that this particular client emailed in. So let’s tackle that first. Perfect. Okay. So here’s how it goes. This client had a decent amount of money. So we’ll just going to use some general numbers so that will help out. And it’s a hundred thousand dollars in cash.

[01:51] Does that sound pretty typical for a lot of people you’re dealing with? It really depends. I don’t know that we have what one would call as a typical client, but hundred grand is a nice round number. So let’s just go with it. Okay. Here is what it is. They’ve got a hundred thousand dollars and now they have a hundred thousand dollar policy loan and they are being charged 8% from that. And so what is happening with that is they’re really trying to figure out what is the reason and the costs associated with that and the commissions and all the other pieces. And they’re trying to look at it of what’s going to be the return, if I recall correctly, and then also looking and factoring the debt. Now you have this in front of you.

[02:39] I think that you have a clearer picture of this than I do, definitely. Well I’ll add one more fact to the pattern. And that’s that in addition to the policy loan at 8%, which we’ll address, they also have a home equity line of credit that would charge them 3.49%. So let’s just call that 3.5 and that’s a fairly common interest rate these days on home equity lines of credits, which may or may not be deductible. Let’s remove the deductibility from the equation because that’s going to be different for different people in terms of home equity lines, but we’ll just focus on the interest rates. And so it’s super, super important that people understand that interest rates do matter. And unfortunately, to go back to our statement of why did my advisor lead me wrong, there

[03:28] are groups of advisors out there that do not understand this area thoroughly. And so they’ll make comments about interest rates don’t matter and that’s not accurate. So this misunderstanding, I’m going to call it, is something that’s common and yet we want all of our clients to know the whole truth. And so in this particular situation, if this client had a home equity line of credit available at 3.5% and we were just looking at the numbers, and that’s a really important point, the comments that I’m going to make are just based on the numbers. They’re not based on a whole bunch of human factors that absolutely play a role in decisions. And maybe we can talk about those too, but if we’re just looking at the numbers,

[04:18] If you have a loan that’s at 3.5% and you have another loan that’s at 8%, clearly the 3.5% loan is the better, more efficient, cost-effective loan to take out or to use. Now in this case, they were questioning, do I move the loan, like move it from the 8% cost to the 3.5? That would absolutely be an option. But they were also debating whether they should pay off the loan because they had So they could make a decision with this, quote, new money, if you will. And an 8% loan is absolutely an acceptable loan. In fact, interestingly enough, we use 8% as our dividing line between what we would call a good, efficient loan, quote unquote, and a not so good, not efficient, you know, let’s try to get it paid off loan.

[05:06] If it’s at 9, 10%, especially in today’s marketplace, then you want to work towards paying that off. If it’s at 8%, well, that’s debatable. And the reason it’s debatable is because we have investments that we can be very confident in that are earning 8, 9, 10%. And so clearly, if you have an 8% loan, you don’t want to invest at 8%. That’s not going to be a win-win. And yet in his case, if he could move the loan from the 8% cost to the 3.5% cost, that would be very efficient. It would increase the efficiency of the loan. And then he could take his cash and invest at 8% or 9% and get ahead. And that’s a very critical distinction is so many times when we have these life insurance loans, advisors and life insurance agents have caused us to

[06:02] believe that there’s some kind of magic in the life insurance loan. And that’s not accurate. And I don’t know why agents and advisors do this actually. I mean, I can guess. And my guess is that the life insurance by itself, just with its basic facts and its basic loan pattern and its basic interest rates, and the dividend scale, etc., is not exciting enough. And so advisors and agents feel like they need to add some element of pizzazz to the life insurance policy and its loan structure to somehow make it more enticing, appealing, exciting, what have you. Now, there are life insurance companies all over this country that charge 8% fixed, and that’s perfectly acceptable. There are others that charge 4%, 5%, maybe 6%.

[06:54] Those are often variable. And we believe that fixed is better, but variable is perfectly acceptable as well. And they are just basic loans. And we don’t need to get all caught up in the fanciness around those loans. Nothing magic is going on. Your life insurance cash value is collateral at the insurance company. The life insurance policy loan is a regular loan payable to the life insurance company at whatever interest rate they’re charging you. And then where people get confused, and again, largely because advisors themselves, I think, sometimes don’t understand and or are just trying to make things fancier, is some thinking that occurred in the 80s about paying extra interest on your loans.

[07:51] Have you ever heard that as a strategy, Spencer, the idea to pay extra interest on your policy loans? Paying the extra interest. You’re not talking principles, you’re talking extra interest. Right. Well, you know what? I’ll have to admit, I’m probably a little too young to have been familiar with that. Well, that’s a good thing. So there definitely was a time in the marketplace when interest rates on regular loans, like on somebody’s home equity line of credit or just a personal loan that you could get a bank, not like a credit card loan, but just a regular loan, were in the 10, 11, 12% range. So let’s just call it 10%. You know, they might’ve even been 12, 13, 14, 15%. But at that time, if there was a loan out in the marketplace at 10%, and you

[08:39] had a life insurance loan available to you at 8%, it was a common strategy to borrow against your life insurance policy at 8%, and then, of course, pay it back, the 8%, which would go to the insurance company, but to pay it back at the rate of 10% in order to be true to what the marketplace charge was. So your insurance company is charging you 8%, but the marketplace would charge you 10%, so you’d pay back your life insurance loan at 10%, even though you only owed 8%. Does that make sense so far? It does. Okay. Essentially, that 2% differential went back to your policy as paid up additions. So paid up additions are a special rider. If you’re new to this podcast, you might want to back up a few and grab

[09:30] some of the various conversations that we’ve had on whole life insurance and paid up addition riders. But essentially, that 2% differential between the 8 and the 10, and that’s a spread, so there are times when spreads are not accurate things to look at, but in this case, that’s what we’re talking about, that would go to paid up additions for your policy. And that worked great when the marketplace was charging 10%. But fast forward to today, and clearly the marketplace is charging more like maybe 6%, so you’re not going to take an 8% loan and quote, pay back extra. I mean, you just wouldn’t do that. It’s not actual in the marketplace. It’s not really normal. It doesn’t make sense financially or economically.

[10:12] If you have an 8% loan, you’re just going to pay 8%. If you have a 6% loan, you’re just going to pay 6%. Again, I reiterate, this base interest goes to the insurance company. And unfortunately, a lot of advisors and agents will use the words borrow from yourself. And that confuses clients and they think that the interest that they’re paying is going to themselves. Well, if they were paying that extra 2%, then yes, that would be a legitimate statement. But in today’s world, that’s typically not the case. So why are advisors using this language? Because in the 80s, it was common and they’ve just never really updated, I think, their thinking. And so they’re using language like borrow from yourself,

[10:57] which is very confusing to clients and it causes them to misunderstand exactly what’s going on. That makes a lot of sense. Now, it sounds like the crux of this problem really happened when it came to understanding the interest rates, is that right? Yes, so to go back to that, if you’re just looking at interest rates and you’re not looking at any human factors, you always want to pursue the cheapest interest rate. Now, if you’re going to add in the human element, human factors that make a difference without a doubt, which is why people have advisors because it can’t always be about just calculating things, like a robot could do that, right? But if you want to add in the human element, it’s very important to understand that, for example,

[11:43] a home equity credit line is going to require a payment every single month. And so, yes, this is at 3.5%. It’s more efficient, but it requires a payment. The life insurance loan doesn’t always require a payment. And that can be good and bad. But clearly, if you’re well-disciplined, that’s a non-issue. If you’re not very well-disciplined, you need to set yourself up on some type of automatic payment so that your life insurance loan gets paid back. And of course, there are other human element things to consider, like whether you want the loan on your credit or not. A life insurance loan’s not going to be on your credit report. A home equity line of credit is. And then there’s one last thing that I want to address that you brought up at

[12:19] the beginning of our talk today, and that’s the area of commissions. Life insurance is a net, net, net product. In other words, when you’re looking at an illustration, when you’re looking at the cost of the loans, when you’re looking at how much your pay to petition goes to cash versus the death benefit, etc., etc., everything that you’re looking at is net. In other words, after the cost of commissions, after the cost of the death benefit, and after the cost of running the company, because mutual companies are typically the types of companies that have whole life insurance. And so a mutual company is run by a board of directors for the policyholders, and of course, part of the money that we pay in

[12:57] runs that company. So again, you’ve got three things from gross to net, cost of the death benefit, cost of running the company, and the cost of commissions. So when you are looking at a loan, and whether you paid off, and etc., etc., do I need to take commissions into consideration? They’ve already been taken into consideration, and they’re really not an issue. You’re looking at everything at a net level. And then one last comment that I want to just share with everybody circles back around to my actual recommendation for this situation. So again, we’ve got 100 grand of cash, we’ve got an 8% cash value loan right now. We’ve got a home equity line available at 3.5. The most efficient, purely economic strategy,

[13:42] not taking into consideration the human elements that we talked about, is to move the loan from the life insurance company with a cost of 8 to the home equity credit line with a cost of 3.5, and then take the 100,000 of cash and invest it at 8 or 9 or 10%. Let’s just use 8 as an example. And then this is a really critical calculation that a lot of people misunderstand, and I used to misunderstand this too, until I really got my arms around a financial calculation based on the rate of improvement from the 3.5% home equity line of credit to the 8% investment. And what that differential is, and it’s very easy to say that that differential is 4.5%, 3.5 to 8, but it’s not. It’s over a 100% improvement.

[14:44] If you just want to round the 3.5 to 4, if you are borrowing at 4. Now, I realize this loan already existed. It’s not like he took the loan out to create the 100,000. But in effect, if we look at this whole thing big picture, because he has 100,000 of cash that he could pay off the loan with, the fact that he’s choosing not to do that indicates that that 100,000 has a 3, so 3.5 to 4, and I’m rounding up to 4, a 4% cost. And he’s able to, let’s say, invest at 8. That’s a doubling of money. That’s 100% improvement. Going from 4 to 8 is 100% improvement, not a 4% improvement. Does that make sense? That makes total sense. And I wonder why most people don’t see that. Because we never switch interest rates into dollar figures.

[15:39] We look at the 4% interest versus the 8% interest, and we subtract one from the other, which is obviously 4. But if you applied dollars to these rates, if you said, OK, I have $100,000, and let’s do it both positive, we would say a loan is negative interest rates, but let’s do it both positive so we don’t get the plus and the minus confused, because this is already a confusing enough discussion without having a calculator to look at. If you took $100,000 and you grew it at 4% for a decent period of time, like 30 years, and you took $100,000 and you grew it at 8% for that same period of time, 30 years, you would clearly see that that was a much bigger difference than just the 4% spread. So it really is back to looking at dollars like you would hammers

[16:38] in a hardware store or fruit in a grocery store that gets marked up. And all that this transaction is doing is marking up money. And that’s basically what banks do. Banks mark up money. So you have dollars that are being marked up, like made into a profit. And just like if we bought a hammer for $4 and we sold it for $8, we wouldn’t call that a 4% profit. That’s 100% profit. And if we bought them at 5 and put them at 8, then we have to use a financial calculator that’s specifically designed to determine the rate in order to understand that difference. And so it’s just something that us human beings are not used to doing. By the way, 5 to 8 is a 60%. I have to do it myself. I can’t do it in my head.

[17:33] I can do 4 to 8 in my head because that’s easy. But it’s just something that we’re not used to doing. But if we applied dollars to it instead of interest rates, we wouldn’t make that mistake. Well, this is so fascinating. And also for our listeners, we love answering these questions and really getting into the details and helping demystify because even advisors, as you were mentioning, sometimes make mistakes. But hopefully, as you listen to this episode, you can understand that you really need to look at the interest rates. And then you need to use some sound calculation and be comparing those true numbers to each other. The best way for our listeners is to email us their questions at hello at partnersforprosperity.com.

[18:20] And I’m going to ask one last question. What’s your favorite part of answering questions here on the podcast? Yeah, I love to answer questions. That is my favorite part, period. And I tell clients on the phone from time to time when they come into the meeting and the entire meeting ends up just being their questions and my answers. And I call those Q&As. That’s my favorite kind of meeting. I will answer questions all day long. It’s something that I love to do. And so if you have your questions, please send them in. Sometimes I’ll reply on email. And then sometimes we’ll do a podcast on it. So hello at partners for prosperity.com. Thank you for listening to the Prosperity Podcast. To take control of your money and have it work for you,

[19:11] visit us at partnersforprosperity.com. If you liked this episode, make sure you subscribe and leave a review.