What is the true cost of borrowing from a life insurance policy?
This is something that virtually everyone - inside and outside of the industry - gets wrong.
Why does Cost of Borrowing matter?
It is important for advisors to help their clients understand the true Cost of Borrowing in their policies.
- Many people erroneously conclude that a bank loan or a home equity loan are a more expensive option than a policy loan due to faulty math. Dangerously, many people conclude (and even advise their clients) that they are engaging in “zero-cost” or “zero-spread” borrowing with minimal cost when the actual cost is dramatically higher.
- Underestimating the true cost of borrowing increases the amount borrowed. This raises the risk that a policy could end up upside down and trigger the dreaded “surrender squeeze.”
- Underestimating the true cost of borrowing also means that most people fail to recognize the very attractive low-risk returns associated with paying off policy loans.
Direct Recognition vs Non-Direct Recognition
Before we look at calculations, it’s important to understand that every loan is classified as either a Direct Recognition (DR) loan or a non-Direct Recognition (non-DR) loan. This varies from company to company, and some companies offer both options.
- DR means that the interest rate credited within the policy on borrowed cash value will be linked, often with a small interest rate spread, to the borrowing rate.
- Non-DR means that the interest rate credited within the policy on borrowed cash value will be the same as on unborrowed cash value and that gross policy values will be unaffected by borrowing.
DR Example
- Fixed loan rate on borrowed funds: 8%
- Interest crediting rate on borrowed funds: 7.8% (assumes 20 bps (0.20%) spread)
- Interest crediting rate on unborrowed funds: 5.1%
So what is the true cost of borrowing?
- It is not 0.2% (8% less 7.8% interest rate) as many people erroneously conclude.
- It is also not 8% (the loan rate) - another common error
- The true Cost of Borrowing is actually 5.3%.
Wait – how did we get to that?
In the example above, the difference between the interest crediting rate on the borrowed and non-borrowed funds was 2.7%.
The borrowed cash gets credited with an extra 2.7% (7.8% instead of 5.1%).
The reduces the true cost of borrowing from 8% to 5.3% (8% - 2.7% = 5.3%.)
If there was no interest spread, then this loan might be misleadingly advertised as a “zero-cost” or “zero-spread” loan. However, the true Cost of Borrowing would simply be the current credited interest rate - not zero!
Non-DR Example
For a non-DR policy, the true cost of borrowing is simply equal to the loan rate.
- Variable loan rate: 5%
- Interest crediting rate: 6%
The true Cost of Borrowing is simply the loan rate, or 5% in this example. Note that non-DR loans often have variable loan rates that change annually based on an index.
Many people erroneously conclude that borrowing doesn’t cost anything in this example. Or, they incorrectly believe that there is even a 1% incentive to borrow because the interest crediting rate is higher than the variable loan rate.
Does your client need a policy review?
I am an Actuary and a Consumer Advocate (not an insurance agent) who helps high-net-worth individuals with $100,000 or more invested in cash value life insurance or annuities to maximize the value of their policies.
High-net-worth individuals and their advisors hire me to help determine:
✔ Which policies to keep, replace, modify, sell, or surrender
✔ If insurance that is no longer needed should be continued, and in what capacity
✔ How to avoid common problems through proper policy design and policy management
✔ How to maximize long-term policy value (instead of agent commissions)
✔ What to do with a policy with substantial embedded gains or losses
✔ How to best utilize the cash value of a life insurance policy to help navigate retirement
✔ What is the true cost of borrowing from a life insurance policy
To learn more, please contact me.