Why Do I have to Pay Interest on Policy Loans?!

One major objection to the Infinite Banking Concept is the idea that in order to leverage capital in a policy (to borrow against the cash value), the borrower has to pay interest to the life insurance company. Some believe that it amounts to “paying interest to use ‘your own’ money.” I address this objection below.

Thanks to Kaye Lynn Peterson for her help with editing.

When an individual policy owner leverages his capital — his cash value — in his policy, he does so with a policy loan. That loan, like all loans, comes at the cost of interest. The life insurance company charges an interest rate on the policy loan. The idea of paying interest to the life insurance company in order to leverage one’s cash value is the subject of some controversy. As we’ll see, the objection that says an individual should not have to pay interest to use a policy loan is the consequence of short-sighted understanding of the nature of interest, policy loans, insurance companies, and, perhaps surprisingly, dividend payments.

Life insurance companies must invest the premium dollars they receive from premium-paying clients in order to meet their contractually guaranteed future promises like death benefits. One of the potential investments life insurance companies can make is in their own clients. They do so in the form of policy loans. In fact, since mutual life insurance clients (policy owners) are also company owners, they have first right of access to the funds that the company must invest anyway.

As with all of their other investments, life insurance companies want to receive a return above and beyond the principal of a given investment. This is true of all of the company’s investments — including policy loans. The interest payment that a policy owner pays the life insurance company is that return. Therefore, when a policy owner pays interest on his policy loan, he is directly supporting the profitability of the life insurance company.

Suppose that you own your own business (maybe you in fact do). If you had the power to directly enhance the profitability of your business, would you use it? Even further, what business owner wouldn’t use this power, if it were available to him? Suppose instead that you are an employee (maybe you in fact are). If you had the power to directly enhance the income you received in your work, would you use it? Even further, what employee wouldn’t use this power, if it were available to him?

Owners of businesses participate in the profits of the business. The mechanism by which an individual participates in the profits of his business is called a dividend. Likewise, an owner of a mutual life insurance company (a policy owner) participates in the financial performance of that company by receiving a dividend. Company profits, and therefore dividends, are the result — in part — of the company’s ability to generate a return in its business and investment activities.

Let’s put this all together. An individual policy owner has the contractual right to participate in the investment activities of a mutual life insurance company through the use of a policy loan. Upon repayment of that policy loan, the policy owner has the ability to directly contribute to the profitability of the company that he owns through the payment of interest on the loan. Therefore, a policy owner has the contractual authority to directly reinforce his own company’s ability to reward his ownership of the company through the payment of a dividend.

Put differently, an individual who complains about having to pay interest on policy loans over which he exercises incomparable contractual control should remember that he is rewarded for doing so with a payment of a dividend. Further, he should recall that he has the contractual right to either receive this dividend in cash tax-free (up to his cost basis) and the contractual right to route that dividend back into his policy through a PUA premium payment. Doing the latter directly compounds the growth in his cash value (capital), which he can use as leverage in the future to start this process all over again.

If a policy owner appreciates the tax-treatment of dividends from mutual life insurance companies, if he likes the idea of compounding growth in his cash value, if he’s interested in the ability to borrow money through a policy loan at his discretion, repay it when, if, and how he wants, and use it for what he wants, then he should not balk at the notion of paying interest on policy loans.

I have heard from an industry veteran, the reprehensible passive endorsement of a related idea: that a policy owner should only pay interest on his policy loans. Per this suggestion, the policy owner should leave his policy loan balances outstanding. Applying what we’ve covered above, we might realize that this is the same as saying that an individual should like to own a company that never gets back the principal of its investments.

Why don’t companies do this? Why, for example, do commercial banks require that their customers repay their loans? Wouldn’t it be grand if the customer maintained the balance and just paid interest forever? Wouldn’t this strategy work miracles for the bank’s income?

Insofar as we consider one policy loan balance — one stream of interest payments — this strategy might be acceptable. But how many people do you know who, over the course of their lifetimes, take out only one loan? Of course people have a tremendous need for capital over their lifetimes! This means many loans. Individuals will purchase multiple cars, take multiple vacations, make many business purchases, and so on. Each instance of a new need for capital is another opportunity to create another loan balance. This additional loan balance means another recurring interest payment.

Entities or individuals who fail to repay their debts are creating situations where service on their debts — the total interest they owe — is their largest expenditure. For how long is such a scenario sustainable?

In the case of life insurance, a policy owner who fails to repay the principal of his policy loans will one day find himself unable to make all of his interest payments. The unpaid interest will then begin to compound the outstanding loan balance. Ultimately, and this is possible, the total balance on outstanding policy loan debt will exceed the cash value of the policy. This is nothing short of total disaster.

When outstanding policy loan debt exceeds the cash value of a dividend-paying whole life policy, the policy lapses (though companies do implement procedures to try to prevent this). At that point, the outstanding balance of the policy loan debt, less premium payments made into the policy, becomes income-taxable in that year. This could mean an income-tax bill on hundreds of thousands of dollars (if not more) all of which was received and used long ago. For an agent to support — either explicitly, implicitly, actively, or passively — the idea that a policy owner should intentionally accumulate policy loan balances in this fashion could be the worst thing he could do to a client.

Therefore, a policy owner should neither balk at paying interest to a company in order to use a policy loan, nor should he intentionally refuse to repay the principal balance of his loans.

By paying interest to the mutual life insurance company, the individual is directly enhancing his own company’s profitability, the reward for which is a highly tax-favored annual dividend payment. By repaying policy loans in full, the individual frees up cash value to be used again as collateral on future policy loans, thereby allowing himself to further contribute to his own company’s financial performance without potentially exposing himself to catastrophic tax liability.

There is one instance where outstanding policy loan debt left unpaid is not catastrophic. This is the case when the cash value exceeds the outstanding loan balance upon death of the insured. In this case, the total outstanding balance is paid by the death benefit. What remains of the death benefit is then paid to the beneficiaries. Though this is perfectly acceptable, it is the individual policy owner’s responsibility to ensure that his outstanding loan balance does not approach the total cash value too closely. This may happen if an individual chooses to use his policy to provide some passive cash flow in his more mature years, as we discussed in Part Three.

However, under no circumstances whatsoever should an agent advise — nor should a client endure — the idea that an individual, over the course of his ordinary lifetime, should intentionally accumulate policy loan balances without repayment.

The above discussion should shed light on another point of worry among some potential policy owners: the exact level of the interest rate. These individuals are tempted to compare the rate on a policy loan to the rate on, for example, a home-equity line of credit, a credit card, or other bank loan. Of course, the individual is free to make comparisons as he wishes, but he should keep in mind the categorical distinction between policy loans and policy-loan interest versus conventional loans and conventional-loan interest.

The underlying collateral on a policy loan is guaranteed by the lender. Consequently, almost all of the terms of a policy loan are under the control of the borrower (policy owner). This is an idea so foreign to us (as are the implications), because this is truly unique in the world of finance to mutual life insurance and policy loans. All sorts of beneficial things for the borrower (policy owner) follow as a result.

There are no lengthy applications, credit checks, or use restrictions on policy loans. The policy owner determines the schedule of repayment. Policy-loan interest is consequently not amortized as in the case of a mortgage. This means the volume of interest paid over the repayment term is disproportionately less than what it would be with a conventional, amortized loan. There are no threatening bill collection calls. There are no physical collateral assignments. Policy loans are not callable in the way that almost all other loans are (I cannot think of a conventional loan that isn’t) as established in the loan contract.

Therefore, beside the fact that policy loans and conventional loans both come at the cost of interest, the exact rate of which is expressed in numbers, the similarities end there. This means that the comparison of a policy-loan interest rate to a conventional-loan interest rate is essentially an apples-to-oranges comparison. The terms of a policy loan are categorically preferable on any number of margins since the underlying collateral is guaranteed by the lender — something that does not happen anywhere else in finance.

There is one final aspect of policy-loan interest rates that confer a benefit — a particular sort of knowledge — to the individual that one will not find in other forms of credit. I must thank my business partner and mentor James Neathery for pointing out to me this particular aspect, because it relates precisely to the subject of this book. It’s this: policy-loan interest rates provide a baseline cost of capital to the individual.

In other words, a policy owner knows explicitly and contractually what his capital is worth at a minimum. He knows that a potential investment opportunity or other use of his capital must generate at least whatever the policy loan rate of interest is in order for the transaction to yield a net positive return to the policy owner. Let that sink in. Do you know your cost of capital? The advanced businessman might; after all, he likely won’t be profitable for long if he doesn’t. Dividend-paying whole life insurance provides the opportunity for nearly everyone to know precisely their minimum cost of capital and on what (highly favorable) terms that capital may be deployed. To say that this is powerful information is an understatement.

Interest on policy loans provided by mutual insurance companies is extremely unique. In a way, it’s an elegant phenomenon. By paying it, an individual directly supports a company he owns, that rewards him for doing so. It allows him to know exactly his cost of capital. It’s a fundamentally different form of interest payment relative to those on conventional loans that have generated such contempt, often rightfully so, among the general public. The reader who can internalize these many differences and the reason for the difference will have enhanced his financial knowledge by orders of magnitude over that of most of his peers.

The policy owner who grasps the full nature of policy-loan interest is not only in full contractual control of his lending activities, but in full cognitive control as well. This is a formidable sort of individual, answerable to no one other than himself for his financial activities.