Let’s be honest: it can be difficult to discern the full truth about policy loans and interest thanks to the misinformation circulating around. While it’s not impossible to come out ahead, even with a loan balance, it’s not a sure thing either. It takes knowledge, understanding, and the right strategies. So, let’s think a little bit deeper about the numbers at play.
For this particular example, let’s assume that your client is earning about 6% net in an account (doesn’t matter what account, for the purposes of this demo). The client also takes a policy loan against their life insurance, with an interest rate of 8%. Let’s see what happens:
Weighing Interest Earned vs. Interest Cost
The client’s account earning 6% also has $100,000 already stored away. Assuming they make no contributions to this account, they’ll have a Future Value of $320,714 in 20 years’ time. So without touching the account, they more than triple the value in 20 years.
The best comparisons are always made with all variables the same but one. Since the interest rates are different, all other figures should be compared equally. So assuming this client has a $100,000 loan he wants to pay back in 20 years, we need to figure out what his annual payment will be. Truth Concepts offers a suite of powerful tools, including the Whole Life Insurance Cash Value Calculator and the Payment Calculator. Using the Payment Calculator, we can see that he has to pay $10,185.22 annually to pay down his loan in 20 years.
WIth this information, now we can find the interest cost. The calculation seems pretty straightforward, right? We just multiply the annual payment by 20, then subtract the initial $100,000 and we’re left with the interest cost. If we do this, we get a total loan cost of $203,704. Which means the interest cost would be $103,704.
Unfortunately, this is where most people stop their calculations. They see that the loan costs less than what they earned, so the case is officially closed. Yet there’s some more information to be gleaned if we take this further, which can help us arrive at the best possible conclusion.
The Missing Link
In order to draw the best possible conclusion, we need to consider all sides of the problem. And there’s one thing missing from the equation: cash flows.
In order to have an equal, comparison, we have to consider the $10,185.22 of cash flow on both sides of the equation. This isn’t to say that the client should cough up another $10k out of thin air. Instead, we must consider: what if he paid off his loan with the $100k earning 6%, and then applied the annual $10k loan payments to the account earning 6% instead?
If he does this, his Future Value in 20 years becomes $374,669. This means that not only does your client SAVE $103,704 of interest cost, but he also has $54,000 EXTRA in the bank after 20 years.
So while it is certainly true that you can come out on top even with a loan balance, it’s not necessarily the most efficient way possible. The reality is that you must consider the cost of money in your equations. Interest shouldn’t be the “end-all-be-all” of your financial decisions, yet it should also be a consideration.
Non-Mathematical Factors to Consider
This isn’t a one-size-fits-all solution by any means. However, we hope that it demonstrates that you must consider something from all angles to find what will work best for your client.
For example, there are also some non-mathematical factors to take into consideration. Liquidity is a big one. If your client chooses the first route and pays down the loan, they’re in a much better position of liquidity in the case of an emergency or opportunity. If this account is their only asset aside from their life insurance, you may choose to keep that liquidity in favor of the interest savings. A middle ground may be to work with your client on a number he would be comfortable contributing to reduce the debt, so there’s some reduction and some liquidity. On the other hand, if the client has many other assets that offer liquidity, it can be a no-brainer to pay down the loan and save the payment.
Another factor to consider is how the client is using the loan. For example, if he is buying a cash-flowing property with the policy loan, you may decide on a different structure altogether. It’s worth doing some calculating to see where that cash flow is going to best be applied. For example, your client may want $100k to be liquid for unexpected expenses with the property. The cash flow could be applied to the loan, and any excess goes into the 6% account. OR, you may decide that your client is better off paying the debt with a lump sum, then applying the excess $10k AND the cash flow to the account earning 6%.
Ultimately, you shouldn’t feel like there is a right way or a wrong way to direct your client. There are only the mathematical facts, and the reality of your client’s personal economy. Be sure to look at a problem from all angles to provide the former, and for the latter be sure to know what’s important to your client. For more insights and guidance on how to help your clients, we recommend signing up for our PEA Linguistics membership.
