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How do I explain the difference between Total IRR and Annual ROR on Life Values?
The Total Internal Rate of Return is based on the cash value (and we also have one based on the death benefit) and it starts very low and increases over time. It usually shows a negative 100% first year because we have zero cash value in the first year but the IRR appreciates and increases over time. It is however, weighed down by the early years as IRR is a “cumulative” column as opposed to an annual column.
Annual Rate of Return on Cash Value calculates the ROR on the cash value for every year without carrying the baggage from previous years. Whereas the IRR calculation has all the previous negative years that are weighing it down. The annual ROR on Cash value looks at each year separately, so you’ll see a positive annual return on cash value earlier, typically around the 3rd or 4th year, sometimes a bit later.
How to tell the whole truth about Direct Recognition.
There are two different methods insurance companies use to handle the loaned cash value — direct recognition and non-direct recognition. In a non-direct recognition company, the earnings rate on cash value is totally unaffected by any loans against cash value. In a direct recognition company, the earnings rates on loaned cash value are affected both positively and negatively when the cash value is used as collateral. Generally, the loaned cash value has a dividend rate that is a certain number of basis points lower than the interest charged on the loan. So if the current-dividend-crediting rate is less than the direct-recognition-crediting rate, then the cash value is affected positively. If the current-dividend-crediting rate is greater than the direct-recognition-crediting rate, then cash value is affected negatively. For example, let’s say the current-dividend-crediting rate is 6.5 percent, and the loan rate is 8 percent with all loaned cash value getting a “100 basis point” (1 percent) reduction from the loan rate (bringing it down to 7 percent). That being the case, since 7 percent is obviously greater than 6.5 percent, borrowing against your cash value actually improves your situation because your dividend-crediting rate will be at 7 percent for the borrowed cash value and 6.5 percent for the non-borrowed cash value. After all the analysis we’ve done on many companies and policies, we’ve found either way works just fine. Maybe consider having both!On the Borrowing Calculator, just left of the first loan, there is a blank white space where you can place your mouse and it will switch to a hand. If you click on this, you’ll see the IRR on the entire deal you are looking at on that calculator.
The Whole Truth about Life Insurance Loans, Simple or Compound Interest?
Investopedia explains Compound Interest as “The more frequently interest is added to the principal, the faster the principal grows and the higher the compound interest will be. The frequency at which the interest is compounded is established at the initial stages of securing the loan.”
Investopedia explains Simple Interest by saying “Simple interest is called simple because it ignores the effects of compounding. The interest charge is always based on the original principal, so interest on interest is not included. This method may be used to find interest charge for short-term loans, where ignoring compounding is less of an issue.”
If your payment frequency is less than your compounding frequency then compound interest occurs between payments. So if you are paying monthly but your financial institution (bank or insurance company) computes their interest daily, as most do, then compounding occurs between your monthly payments every single day.
Most bank loans charge compound interest because the interest frequency is daily (compounded on a daily basis) and payment frequency is monthly, therefore there is interest charged on interest daily as it accrues throughout the month. Then the monthly payment wipes out the accrued interest and some principal, and the process starts all over again.
In the same fashion, a life insurance loan is most often compounded daily and the payments are made either monthly or annually so it too is a “compound interest loan”.
For example, if a companies APR is 5.5%, the daily rate (because they compound daily, like most banks) is .014669% (or .00014669). If you multiply .00014669 times 365 (days in a year) it equals .05354185 or 5.35%. So why is the sum of the daily rates (5.35%) less than the stated annual rate of 5.5%? The answer is that 5.5% is the actual APR (just like at a bank) and takes into account the daily compounding that has occurred.
By the same token, many people discuss credit card that charges 1.5% per month as if it were an 18% annual rate. However, in reality, 1.5% per month is actually 19.56% per year as shown below.
To say a loan with a life insurance company is simple interest and not compound interest is entirely false. If it were true, you wouldn’t get credit back (at interest) for making loan payments between anniversary dates.
Life Insurance Loans, In Advance or in Arrears?
The Whole Truth
An issue that is often incorrectly talked about as an advantage, is the idea that the insurance company charges a lower interest when interest is paid up front (in advance) versus at the end (in arrears). The whole truth is that there is a different factor (not a different interest rate) used to calculate the amount of up front interest that has to be paid. This factor can be calculated by reducing the Annual Interest Rate by the Annual Interest Rate. Yes you read that right!
The calculation looks like this. In order to figure out the factor used to calculate the amount of interest to pay in advance, you need to use a Present Value Calculator. Assuming the insurance company states they have a 5.5% loan interest rate, then as shown in the example below, you put 1.00 as Future Value, no payment, 5.5% as the Interest Rate and 1 year. This equals .947867298578199.
When we subtract that .947867298578199 from 1, we get .052132702 so now we know what the beginning of year factor is. It is 5.2133% (rounded).
You can see why people looking at these 2 numbers (5.5 v. 5.21) think that the rate of interest charged is less when paid up front. In reality the annualized rate is 5.5% (the end of year rate) regardless of whether the interest is paid up front or in arrears.
The factor (5.21%) shouldn’t be confused with an interest rate as its only a factor used to determine how much interest to pay when paying up front. It is true that the amount of interest you pay when paying up front is less than the amount of interest you pay when paying at the end of the year, but the reason for that is simply the fact that you didn’t borrow as much money.
For example: if you have a loan of $10,000 at 5.5% APR and you pay the loan at the end of the year, you’ll have to pay back $10,550. If you pay the up front interest of $521.33 (10,000 * .052133) then it means that you’ve only borrowed $9,478.67. When you multiply that $9478.67 by 1.055 (1 + 5.5%, our APR in arrears) it equals $10,000 which means you paid 5.5% on the amount you actually borrowed. Insurance companies bill for their interest up front so they make sure they get the interest.
Another way to look at this is $9478.67 (the amount we actually borrowed) multiplied by 5.5% (interest rate charged in arrears) = 521.33 (the interest charged) and when you add 521.33 to 9478.67 it equals $10,000 so in summary, it is true that you pay less interest when you pay up front because you’ve borrowed less, not because the rate is lower. The rate is exactly the same in both scenarios.
Life Insurance Loans: Where does the interest go? The Whole Truth:
Life insurance companies charge interest when we borrow their money just like banks and credit unions and other financial institutions do. Many statements are made in the market place about how we borrow our cash value. This is incorrect.
The whole truth is we borrow against our cash value, or to be more specific we borrow the insurance companies’ money and use our cash value as collateral. They charge us interest for this privilege because we have now removed money from the pool of capital they have to invest.
This is a good deal for everyone because the insurance company earns money, the owner of the policy gets use of the money while at the same time their cash value keeps growing and all the other policy holders know the insurance company is investing their money properly since the interest charged is reflective of the rates in the market place.
One might question the “market place” rate. Some companies charge a fixed rate, some charge a variable. Some have both available due to direct recognition.
There are two different methods insurance companies use to handle the loaned cash value — direct recognition and non-direct recognition. In a non-direct recognition company, the earnings rate on cash value is totally unaffected by any loans against cash value. In a direct recognition company, the earnings rates on loaned cash value are affected both positively and negatively when the cash value is used as collateral.Generally, with a direct recognition contract, the collateralized cash value has a dividend rate that is a certain number of basis points lower than the interest charged on the loan. So if the current-gross-dividend-crediting rate is less than the gross-direct-recognition-crediting rate, then the collateralized cash value is affected positively. If the current-gross-dividend-crediting rate is greater than the direct-recognition-crediting rate, then collateralized cash value is affected negatively.
For example, let’s say the current-gross-dividend-crediting rate is 6.5 percent, and the loan rate is 8 percent with all loaned cash value getting a “100 basis point” (1 percent) reduction from the loan rate (bringing it down to 7 percent). That being the case, since 7 percent is obviously greater than 6.5 percent, borrowing against your cash value actually improves your situation because your gross-dividend-crediting rate will be at 7 percent for the borrowed cash value and 6.5 percent for the non-borrowed cash value.
After all the analysis we’ve done on many companies and policies, we’ve found either way works just fine. Maybe consider having both!
The interest charged by the insurance company goes to the insurance company, not to your policy directly. The reason for this is that when you borrow dollars from the insurance company, it comes out of the insurance companies’ investment pool and therefore they need to charge an interest rate for it to re place the interest they would have lost if it had stayed invested.This interest does not add to your cost basis or directly increase the policy’s cash value that is being collateralized. However, the earning of the life insurance company (both from their investments in the market place as well as their investments in policy loans) are what they use to pay dividends to all policy holders.
If you choose to pay at a rate higher than what the insurance company charges, then this higher amount (the difference between what they charge and what you pay) can go to your existing policy in the form of a Paid Up Addition (PUA) which would increase basis, or to a new policy as premium so either way that can go to build your cash value.
As a reminder, PUA money goes 95% or so to cash value with only 5% or so increasing death benefit. This drastically raises the amount available to you for use in future years and is the most efficient place to store cash.
How do I input an inforce ledger into the Life Insurance Values worksheet?
In the Permanent Life Insurance Tool, Select radio dial “Inforce”. A box will appear asking for Existing Cash amount. Enter the Cashvalue on the policy’s current status report in this box.
Next to it, an “As of:” box will appear, allowing you to select the date that the status report was ran.
Below that, is a field to enter the next Anniversary date of the policy. This is also on the Status report.
If you do not have access to a Status report and the previous cash value, all you can do is move everything 1 year forward.
So for example, If you are in year 9 of the policy, use year 10 as the starting place (the cash value & DB for the first year in the calculator should be the EOY cash value from year 10 and so-on down the illustration). and use the EOY year 9 cash value as the “Initial Cash Value”.
Once this is entered, populate Current age or policy year, Description, and then paste premium, death benefit and net cashvalue values from the illustration software into the spreadsheet and save.
Premium- Use Net After Tax Outlay column from the illustration and put into Annual Premium column in the PLI Values table.
Policy Loan- If there is a loan on the policy, Use the Cumulative Loan column from the illustration and enter into the Loan Balance column in the PLI Values Table. You use cumulative loan because the loan plus the net cash value is what is actually growing in the policy.
The Life Expectancy tables in the Truth Concepts Calulators “Tools” section show the AVERAGE number of years a particular person will live. You can choose the age, male/female, standard/preferred, smoker/non-smoker and joint/single. Then remember that the number of years you see in the L.E. column is an average. For example, when a 35 year old male, preferred, non-smoker turns 65, there are 20.78 years of his life remaining on average. This means 50% of the people will live longer than 20.78 years and 50% of the people will live less than 20.78 years.
