Where Does the Money Come From?

Many wonder whose money you borrow when you leverage a Participating Whole Life Insurance Policy for a loan.  And the simple answer is, NOT YOURS. And that is one of the best reasons to use such policy loans to build equity.

It’s been said that Warren Buffet’s father took him aside when he was around 7 years of age and showed him that, “The best way to build equity is with someone else’s money.”  And, the rest is history, as the saying goes.

With Participating Whole Life Insurance, policy owners pay level premiums to the insurance company and the company assumes the net risk and pays a death benefit when the insured dies. The net risk to the company is reduced by the returns earned on investments made with premiums paid by all policy owners.

As net risk, plus required reserves, equals the face value (death benefit) of a whole life insurance policy, it is no surprise that initially reserves are lower because expenses and other acquisition costs have not been overcome.  But as time progresses, reserves replace more and more of the risk the insurance company has assumed, and this allows a Participating Whole Life Insurance Policy to develop cash values. By the time the policy matures, the insurance company will have completely replaced all of their risk with reserves.  This permits cash values of a Participating Whole Life Insurance Policy to equal the face value (death benefit) at maturity.

As you can see, company reserves and policy cash values are very closely linked.  So much so that when you take a policy loan from a Participating Whole Life Policy, you are in fact leveraging the face value of the policy. The insurance company merely lends you the money they have been storing in reserve to offset the risk they are assuming on the policy.  Doing so doesn’t increase their risk because even if the insured dies while there is an outstanding loan against the face value of the policy, the insurance company simply deducts that from the face value of the policy and pays the difference to the beneficiary(s) as the death benefit.

Consequently, leveraging a Participating Whole Life Insurance Policy by taking a loan is, in fact, using other people’s money just like Warren Buffet’s father instructed him to do at an early age.  And the beautiful thing is, the Participating Whole Life Policy contract allows you to control how long you leverage that money.  All that is required of you is to pay the interest on the loan.  When and how you pay the principle back is entirely up to you.

Participating Whole Life Policy loans are interest-only loans.  And that means as long as you can earn more money using other people’s money in this fashion, you don’t have to rush to pay back the principle.

Here’s an example of borrowing from a bank and borrowing from a life insurance company.

  • Ann borrows $10,000 from her bank for 5 years at 5% APR. She then makes an investment with that $10,000 and earns an average 8% return over the next 5 years. (Note: The average return in this particular case is identical to the actual rate of return – not always the case.)
  • Jill leverages her Participating Whole Life Insurance Policy to borrow $10,000. She too pays 5% back to her insurance company for the use of that $10,000. Jill then makes the same investment Ann did.

After five years, the $10,000 Ann borrowed and invested has grown to be $14,693. Ann made loan repayments out of discretionary income to her bank of $2,310 each year for the use of the $10,000, and now after 5 years, she has $3,143 of profit. [$14,693 – ($2,310 X 5)].

Jill in the meantime also accumulated $14,693 just like Ann did.  Jill has paid the insurance company 5% each year ($500/yr) on her $10,000 outstanding policy loan from her discretionary income.  Jill’s total interest payments are $2,500 for the past 5 years.  Having only payed the interest and not the principal, she has enjoyed more cash flow over the past 5 years, but that now leaves Jill with $12,193.   If Jill pays back her policy loan at this point she will have only $2,193 to show for her efforts while Ann has $3,143.  But wait.  We must also remember the fact that Jill continued to earn a return on her $10,000 of policy cash values over the past 5 years. When you add those returns, which are $2,635, to her $2,193 of investment profits, Jill ends up with $4,828 which is 53.61% more money than Ann was able to generate over the same time period.

Of course, you can see that Jill ended up paying more interest than Ann did, $950 more to be exact.  And this extra interest gave Jill a better tax deduction as she gets to claim $2,500 of interest deduction while Ann only gets to claim $1,550.

Without a doubt, both Ann and Jill have followed Warren Buffet’s father advice which he shared with his son at the young age of seven.  But Jill has multiplied her earnings while Ann has limited herself to merely adding.  Ann leveraged $10,000 and made it work for her for 5 years.  Jill managed to have $20,000 working for her over that same time period because she leveraged her Participating Whole Life Insurance Policy. And because of this fact, Jill earned more and profited still further by enjoying a larger tax deduction.

You see, when Jill borrowed $10,000, she leveraged her policy. She did NOT borrow her own money!  The insurance company loaned Jill that $10,000 out of reserves.  By using the insurance company’s money instead of her own, Jill was able to earn a return both in her policy AND on the money that she borrowed from the insurance company, against her policy.  That is smart money management.

Even if Jill and Ann take this same $10,000 and invest it at 5% for 10 years instead of 5, Jill still comes out ahead.  They both turn the $10,000 into $16,288.95 over the next 10 years. Ann loses $2,950.46 to interest over that 10-year period and therefore she is left with $13,338.49.  Jill, on the other hand, ends up with $17,204.95 because, even after paying more in interest ($5000 instead of $2,950.46) Jill gets to keep the growth that her PWLI has provide over those 10 years.  This means she ends up with 28.99% more money than Ann. And again, Jill gets the higher tax deduction for the interest she gets to claim for taking an investment risk.

So, where does the money come from when you take a policy loan?  It’s comes from the insurance company (someone else’s money).  And that means you can invest money just like Jill did, and keep more money of the money you make.  And in doing so you can enjoy larger tax deductions.