Premium Finance

It has become fairly common to hear of some agent or brokerage offering premium financing for prospects and clients to purchase more life insurance.  And although this sounds magical and enticing, there is always a cost to using somebody else’s money.  And it is always in your best interest to know what that cost actually is before you eagerly follow the rainbow of premium finance and find it leads to a lump of coal instead of the promised pot of gold.

The concept of premium finance appeals to those who truly believe that you can get something from nothing in life.  But, then again, if you’ll buy that you might as well have the Golden Gate thrown in as well.  Everything costs something.  There is no free lunch, as Milton Freidman emphatically declared many years ago. Ironically, things haven’t changed dramatically since then as far as the laws of economics are concerned.

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So, here’s how premium finance is typically presented.  You put up some form of collateral and someone else loans you the money to buy a life insurance policy. The policy’s accumulated cash value or paid-up life insurance (depending on whether it is a universal Life product or a whole life product) is supposed to grow more than what the policy loan was over time.  Then you can either cash in the policy and pay the loan off, or you can borrow against the cash value and pay the original loan off and you’ve supposedly got yourself a life insurance policy that is worth more than what you paid for it.

The catch is this.

If you cash in the policy and pay off the loan then you could owe taxes on the difference between what has been paid in premiums and the cash value that has accumulated.

Secondly, if you borrow against the policy instead of cashing it out, then you will own interest for the policy loan and you will now have gotten yourself into a position where you are paying interest twice on the same money.  This is similar to borrowing from your IRA or 401k plan.  Yes, you “get” to pay it back with interest that goes into your account but the interest you paid was paid with after-tax dollars and then when you retire and take out distributions from your IRA or 401k you pay taxes on that money again.

I don’t know about you but I don’t like paying interest on money once let alone twice and I certainly don’t ever want to pay taxes on the same dollar more than once. So, why would anybody get involved in premium finance to fund a life insurance policy?

Well, this may be why someone is fooled into believing that premium finance is worthwhile.  An agent or brokerage firm, encourages someone, a business or a family to purchase a large cash value life insurance policy.  After funding it for a year, maybe even two, three or four years, they are told to borrow from that policy to fund a second policy, with the same or lesser premium, and continue to do this adding a third, fourth and even more policies.  They call it laddering or stacking but in reality, it is just using somebody else’s money to finance another policy that you may or may not be able to comfortably afford. And that means the interest and premiums on these policies can create a huge headache for you financially down the road.  By that time, however, the agent or brokerage is gone or is onto some other newfangled idea of how to make something from nothing and the policyholders are left hanging in the wind to dry.

The facts are pretty obvious if somebody really wants to examine them.  If policy one has an annual premium of $10,000 the cash value will be sufficient enough for you to borrow from it to fund policy two in year two.  And policy two will have sufficient cash value for you to borrow from it to fund policy three by year four from when you first purchased policy one.

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But in reality, what happens is that policy one runs out of cash value by year 3 and you end up having to come up with another $3,548.91 just to keep it from lapsing.  Even if you begin a second smaller policy consisting of only the paid-up insurance rider premium that you dropped off the first policy after year one, the cash value in policy one disappears in year 8! This can leave you holding the interest costs and possibly even the taxes due on one, two or more policies that have lapsed leaving you owing more money than what you have paid in premium.  And that is never a good feeling when the tax man comes looking for money from you that you haven’t made or benefited from except on paper.

Here the straight scoop. Life insurance premiums actually drop considerably the larger the premium you pay into a life insurance policy.  That is because the annual fee for participating whole life insurance is flat not a percentage of what your premium is like universal life insurance products.  Secondly, the younger you are the less you pay for your life insurance.  So, it behoves you to pay the largest comfortable premium as possible to any participating whole life insurance policy that you purchase.  But it can also be beneficial to drop the paid-up additional insurance rider off such a policy in order to afford to purchase more permanent insurance on your life rather than pay that paid-up insurance rider as long as you can because coverage gets more expensive as you get older.  Regardless, purchasing life insurance through premium finance is not fiscally sound or reasonable.

Here is a list of things to protect yourself from the premium finance broker/dealers who are more interested in earning a commission than protecting your best interests:

1. Only purchase life insurance that you can afford the premium on.
2. Never purchase a life insurance product that you are not completely comfortable with.
3. Be careful when someone tells you to leverage one life insurance policy to initially fund, pay the interest or sustain the premium on another life insurance policy.
4. Always plan to pay the interest on any policy loan from your income stream not with borrowed money.
5. Realize that the use of other people’s money cost money. So never leverage your policy for a policy loan unless you can comfortably and affordably repay that loan and the interest.
6. Keep money you borrow against your life insurance policy working for you in such a way that you can recover the cost of the interest the insurance company will charge you for that loan.  This will allow you to profit the most from the dividends your policy provides you with.
7. Never pay premiums with a policy loan, a line of credit or any other source of capital that requires you to pay interest payments unless it is for a short duration and you have a plan and the ability to repay that policy loan quickly and comfortably.

Doing these 7 things keep you from finding yourself behind the eight ball, facing IRS in an audit due to policy cash values that became income for you overnight without you ever benefiting from that income, or worrying about how you are going to afford your next premium payment on a life insurance policy you are depending on to cover your liability and income should something happen to you.

Some things are worth waiting for:  Love and money happen to be just two of the things well worth the wait.  There isn’t any fast way to make an honest dollar.  Those who have earned their money, have earned it by becoming more knowledgeable, more savvy, more saving, and more productive.

Leveraging the cash value in life insurance isn’t magic.  It won’t make you rich overnight.  But it can make you wealthier over time if you carefully follow the principles of good money management.

Keeping things at a pace you can comfortably and easily afford to sustain will prove your best, because as you progress down this road you will keep more and more of what you earn rather than attempting to get something from nothing.

Dr. Tomas P. McFie

Most Americans depend on Social Security for retirement income. Even when people think they’re saving money, taxes, fees, investment losses and market volatility take most of their money away. Tom McFie is the founder of McFie Insurance which helps people keep more of the money they make, so they can have financial peace of mind. His latest book, A Biblical Guide to Personal Finance, can be purchased here.