People often contact me about whole life insurance as an investment. They want to see what the rate of return will be, compared to some other investment that they are considering. I want to be completely clear: I do not, have not, and will not sell whole life insurance as an investment. However, you can (and should!) use your available cash value to purchase investments.
Creating a banking system using whole life policies is a process. When you implement this process, you are making a conscious decision not to follow the traditional process of storing your wealth in commercial banks. One of the many positive effects of this decision is that your investment returns will be greater than those of other people making the same investment.
This happens because you are effectively getting to spend the same money multiple times.
Let’s look at this in greater detail. Today, we will compare purchasing an investment with cash, with a Home Equity Line of Credit, and with a whole life policy loan.
Time is Your Greatest Ally
Time can work for you or against you. In my experience, people focused on the short-term always lose to people who look plan further into the future. The rare exception may exist, such as the person who wins a slot machine jackpot on their first try. However, it is the gambler’s orientation towards the future that will determine how wisely those earnings are spent.
A common question is, “What would you do if you suddenly had a million dollars?”
We all know someone who could steward those million dollars and turn them into a lifetime of wealth. We all also know someone who could spend the entire sum in six months, looking to the same casino for another win when the funds had evaporated.
Which one are you? Which one do you want to be?
Setting up the Analysis
When looking at a using a whole life insurance policy as a bank, it’s easy to get caught up with point at which the dividends earned by the policy is likely to make the entire policy “cash flow positive,”—in other words, the point at which all of the expenses of the policy, the base premium, the rider expenses, and all of the funds put into Paid-Up Additions (PUAs)—is surpassed by the total available cash value.
There are other articles on this site to address the potential profitability of each component of the policy. Today, I want to focus on using policy loans to invest in other ventures, and what the “cost” of this really is.
For our analysis, let us consider a hypothetical male named John Doe, age 40. He is a non-smoker and has developed an interest in stock market investing. He didn’t fully understand the power of using whole life as his own private bank, but he decided to put $10,000 per year into a policy for 5 years and see what he could do with it after that. It is absolutely possible to take a policy loan out in the first year, but “capitalizing” the policy for a few years up-front makes the analysis easier. It’s also more in line with the examples in Nelson Nash’s incredible book, Becoming Your Own Banker.
Please note, as always, that dividends on a whole life policy are not guaranteed.
Let us assume that after 5 years, the available cash value in this whole life policy is $44,500. (The actual total will necessarily vary based on dividends paid, design of the policy, the life insurance company used, and so forth.
Investing Without Whole Life
The foundation of any economic comparison should always be a comparison. For example, “I got a 10% return on my investment!” Is that excellent, mediocre, or terrible? It depends on what it was, how much risk was taken, how long it took to earn that return, whether the return is taxable, and several other factors.
Let us look at John Doe making an investment in his chosen field, the stock market. We want to see if he is better off making the investment with cash from his bank account, or with a policy loan against his whole life policy.
John has $44,500 in his savings account at Generic Bank.
He sees potential to earn excellent returns on a stock that he feels is currently undervalued. He takes $40,000 out of his savings account and buys shares of the stock.
Just over one year later, his holding of the stock is sold at $48,000. He is rewarded for his smart investment with a 20% return!
For simplicity, let us assume a 25% capital gains tax rate. (Yes, long-term capital gains are currently much lower than this.)
25% of $8,000 is $2,000, so his earnings after taxes were $6,000.
That means his total rate of return after taxes was 15%.
Over the same year, his savings account at Generic Bank had only $4,500 in it. Assuming he left the funds in the account untouched for the entire year, he might earn one half of one percent on his money. In this case, that would mean $22.50.
His stock market return plus his earnings from Generic Bank would be $6,022.50.
Investing With Whole Life
Let’s run the scenario again, but this time John decides to finance the stock market investment with a policy loan against his whole life policy.
John has $44,500 in cash value in his life insurance policy. He takes out a policy loan of $40,000 to buy shares of the same stock.
Just over one year later, the stock is again worth $48,000—the same 20% return before taxes.
Let’s take out the 25% capital gains tax, so we are now down to the same $46,000 net return.
The policy loan also costs money. Let’s say it’s 5% per year.
5% of $40,000 is $2,000, so now the return is down to $44,000.
I can hear you saying “But Luke, I thought you were going to show me that investing using a policy loan is better than using cash from a bank account! This looks worse!”
Using whole life as a bank is all about how you think. There are two things missing from this analysis right now. Once we factor those in, I suspect you will see the power of this idea.
Earning Money While Spending Money
The first thing that’s missing from the above example is that a whole life policy will earn a dividend, when one is declared by the insurance company. With a non-direct recognition company, the full dividend is earned even when there is a policy loan outstanding.
In our example, John Doe will receive his stock market returns and a dividend on the entire $44,500 cash value in his policy. Dividends will vary from year to year, but to keep the numbers simple we will assume 5%. That means John earned $2,225 totally tax free.
To recap, his final total was $44,000 after taxes and interest on his policy loan. At the same time, his policy generated $2,225 in dividends. That means his return using this method is $46,225.
That’s $225 more than he made using the cash from his bank account!
“Okay,” you say, “Big deal. It’s a 15.56% return instead of a 15% return.”
We’re just getting started. Let’s add the final piece of the puzzle.
The biggest difference between these two methods is the cost to make the investment in the first place.
The cost of the bank account method is easy to calculate. John Doe must remove $40,000 from his bank account to buy the stock. His cost is obviously $40,000.
Returning to the beginning of our analysis, you might be tempted to say that the cost of the policy loan method is $50,000. After all, John Doe put $10,000 per year into this policy for 5 years. That’s true.
Even if he stops buying Paid-Up Additions, in this example he would still have an annual expense of $3,000 for many years to come.
So how on Earth is this a better deal?
Well, the money going into the policy is buying life insurance. If something happens to John, at this point he would have around $250,000 in death benefit that would be payable to his family. Every time dividends are earned and re-invested into the policy as Paid-Up Additions, the death benefit increases.
The product here is not a bank account. It is a life insurance policy. The ability to use the policy loans at a low interest rate is a feature of that product.
In the same way, if you use a Home Equity Line of Credit (HELOC) to buy something, do you complain that you first “had to buy a house” in order to loan money against it?
Of course not! You want a house to live in it. Likewise, you want a life insurance policy to protect your family against the sudden loss of your life.
Whole life is often criticized for being more expensive than other types of life insurance, but that is a broad topic that I have covered elsewhere.
Calculating Return on Investment
The importance of this distinction cannot be overstated.
If the $40,000 is taken from a HELOC at 5% for one year, what is the cost of making the investment? It’s not $40,000, it’s only the 5% that you pay to access the funds. That’s only $2,000.
Likewise, if you take a $40,000 policy loan out, the same rule applies. Your cost of making the investment is $2,000.
If you can use $2,000 to make $46,225 net profit, that’s a 2,211.25% return on your investment. (The simple formula for calculating ROI can be found here.)
So, which do you want? 15%, or well over 2000%?
In case you feel that I am manipulating the analysis to favor my strategy, consider that the same funds can be loaned out again. After this stock investment, John can make another, then another, getting the benefit of uninterrupted compounding all along the way. Each investment can be larger than the last one.
Even if you insist on counting the $50,000 spent building this policy as a “cost” for the first investment, you can’t count it for the second time the money is used. (Or the third, or the fourth…)
Why Not Just Use a HELOC?
You may already have plenty of equity in your home. Seeing the example of a HELOC may tempt you to use that equity in a similar way.
First, HELOCs are callable loans. That means that if the bank sees the need to do so, they can demand repayment in full at any time. A stock market crash, housing market crash, or other major economic situations could trigger a drastically different repayment schedule than you planned on. Policy loans are non-callable. You can go years without making a single payment, or pay it all off days after taking the loan.
HELOCs often have additional rules and fees. You may be penalized for early termination, failure to carry a minimum loan balance, or even failure to take out a certain amount of new loans each year. Policy loans have an annual interest rate, and that’s it. No surprises.
HELOCs are leveraging your home. When (not if) there is a decline in the housing market, you could potentially owe more on your HELOC and mortgage than the entire value of your home. That means that if you want to sell your home, you can’t “roll the equity into the next house.” You may not be able to sell at all, without spending extra cash to clear some of those debts. The value of your life insurance policy cannot decrease. It is guaranteed to increase every year, even if no dividends are paid.
A HELOC is not an asset that you own. While it may look attractive to have some liquidity in your home, the nature of this agreement is very different from a life insurance policy. The bank sets the rules of the HELOC. You own your life insurance policies, and you control the banking operations you use them for.
It’s About Control
As a policy owner with a mutual life insurance company, you are also a part-owner of the company. This is where the dividends come from—the profitability of the company that you own a piece of.
When you put your money in a bank, you live on the bank’s terms. When you use properly structured whole life insurance policies to conduct your financial affairs, you live on your terms. You have more flexibility, more options, and more control over your financial dealings than almost everyone.
The Next Investment
One final consideration may prove useful when examining these two approaches to purchasing investments. How much is available for the next investment?
If John Doe pays cash: He started with $44,500 in his bank account. After selling his stocks and paying taxes, he deposits his $46,000 back into the bank. $46,000 plus the $4,500 still in the bank, plus the $22.50 his savings account earned equals $50,522.50.
If John Doe uses whole life insurance: He started with $44,500 cash value in his insurance policy. After selling his stocks and paying taxes, he pays off his policy loan with $42,000 and puts the additional $4000 in the policy as Paid-Up Additions. The available cash value in his policy would be more like $53,000.
The bank account will work exactly the same way, every single time. The HELOC, too, will work the same way. Whole life insurance policies get better every single year, guaranteed. That means the gap in performance we have seen in this article gets wider every year.
This policy was only 5 years old. Consider what kind of dividends the same policy might be earning after 10, 25, or 50 years…especially if the profits are also put in the policy to grow!
What if I Make a Bad Investment?
Investing isn’t all sunshine and smiles, after all. What if the company that John Doe purchased stock in suddenly goes out of business, rather than making him money?
The Cash Method
If he spent cash from his bank account, that would hurt! His bank account balance decreases from from $44,500 to $4,500, and stays there until he makes more money. Ouch!
The HELOC Method
What about the HELOC? Well, John can carry the balance subject to the rules listed above. Without any payments being made, that balance would be $42,000 after one year, $44,100 after two years, $46,305 after 3 years, and so forth. Just remember that the loan is callable, and you run the risk of the loan balance outpacing the equity in your home, especially when the housing market is down. This is not a position you want to find yourself in!
The Policy Loan Method
Since we assume that the HELOC and policy loan rates are exactly the same, what happens if John has leveraged a policy loan? Well, he has options with the use of his dividends:
- He can choose to let the dividends continue to buy more PUAs in his policy so its cash value will continue to compound. In this scenario, after three years his his loan balance will be $46,305, just like in the HELOC. However, the entire policy earned dividends. On top of that, the policy’s cash value increases in multiple ways. So, the policy’s cash value three years later would look more like $63,500. (That’s $17,195 net of the loan balance, that could be used for other investments to help repay the loan!)
- He can let the dividends directly pay the loan balance. This isn’t as straightforward as it sounds, but suffice it to say that the policy loan balance would grow much more slowly, and the policy’s net cash value would continue to increase! (However, the cash value would increase more quickly if the loan was repaid normally.)
- He can receive the dividends as cash, (tax-free up to his total cost basis in the policy) and use these to help pay down the loan. This is essentially the same method as above, it just goes to John’s account at Generic Bank first.
A Different Way to Think About Debt
Debt is a word with a truly terrible reputation. Rightfully so, when we consider the astounding power that people give banks over their lives on a regular basis. I cannot stress enough that a policy loan from a mutual life insurance company bears little resemblance to working with a traditional bank. In fact, it might be better to think of a policy loan as a “laissez-faire loan.”
Yes, the loan balance is going to increase if you don’t pay it back. But that’s fine, as long as you have the discipline to make payments when you can.
Every time you make a loan payment of any size, more of your cash value is “freed up” to be used again. Following this method and putting only $4,000 of investment returns per year into the policy, what would it look like 30 years in? Something like this:
- ~$398,000 of available cash value.
- ~$21,000 increase in cash value in that year alone.
- ~$635,000 of death benefit payable to John Doe’s beneficiary at the time of his death.
- ~$168,000 net profit on the policy itself, to say nothing of his investments in the stock market.
Since John Doe is 70 by this time, maybe he is looking for a stable cashflow as he starts to work less. Could he completely replace the bank and finance his grandchild’s first home? You bet he can! His grandson or granddaughter can buy a house in cash, then make payments directly to their grandfather’s “bank!”
As a final note, the performance of the policy has been intentionally understated throughout the article.
Ready to get creative and see how this strategy can change your own financial life? Contact me here!