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.

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!

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.