How to tell the whole truth about Direct Recognition.

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.

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.

How do you calculate the cost of paying a life insurance premium monthly instead of annually?  Get a Rate Calculator from www.truthconcepts.com.  Put the annual premium in the Present Value as a negative number (which changes it to Loan Balance) since the insurance company is loaning you the annual premium and you pay them back monthly.  Then make the mode “monthly” and “beg” for beginning of year since the insurance company loans you money at the beginning of the period.  Put the monthly premium payment in Monthly Payment box and the Months as 12.  In the following example, the interest charge the company assesses you for paying monthly is 6.5%. 
 

Would you buy a $50,000 car yet only insure it for $30,000 because you only NEEDED a
$30,000 car? NO! and yet the life insurance industry does this all the time with people by completing a “needs analysis” to determine how much life insurance you “need”.  YOU don’t “need” any, but you family may.  However, trying to figure out how much THEY need is an exercise in futility.  Oh, and the thought that single people don’t NEED life insurance? It’s as correct as saying they aren’t worth anything.

So, how does one figure out their own Human Life Value?  Life Insurance Companies have rules of thumb they use, such as 15-30 times income or 1 x net worth.  Typically for someone between the ages of 20 and 30, Human Life Value is 30 X income.  Age 30-40 HLV is 20 or 25 X income.  Age 40-50 is 15 X income.  Age 50-60 and beyond is 10 X income.  Any age can use the 1 X net worth rule of thumb and this can be up to 2 X depending on business owned and asset base in existence.

We can use the www.truthconcepts.com software to figure it out more specifically.  There are 2 ways.  The quick way is to use the Maximum Potential calculator, the slow but potentially more accurate way is to use the Cash Flow calculator, the Present Value calculator and then the Cash Flow calculator again.

Looking at the Maximum Potential calculator, put in the number of years until 65 (that’s a retirement fallacy, addressed in another article) the income and NO other data.  So in the case below, we have a 30 year old with 35 years until 65 and currently earning $100,000 per year.  Obviously the income will increase over time, but for this snapshot, the information is accurate.  Human Life Value changes over time as income and net worth change. 
 
 
 

You’ll notice above on the right, the potential is 3.5 million for this person.  While that is slightly higher than the rule of thumb mentioned above, it is a guideline for Human Life Value.

A more specific way to determine HLV (and a way to tell the whole truth about what it would take a family to live in their current world if the main income generator dies) is spelled out below using 2 Cash Flow calculators and a Present Value calculator.

We’ll take a 35 year old earning $100,000 with 4% annual raises, and a 5% earnings on assets capacity.  The Future Value of that scenario is $16,484,000 in the bottom right. 
 
 
 

Then you take that $16,484,227 Future Value and using the Present Value calculator reduce it back to figure out that it would take $3 million of today’s dollars to replace that future earnings stream, assuming a net 5% rate. 
 
 
 

More importantly, that $2,998,430 goes to zero in 35 years, so the widow will have to save a portion of that $100,000 – just as the family did when everyone was alive – in order to have a continued income stream past the 35 year period.  Notice the account rises a bit first, and then shrinks to zero. 
 
 
 

Moral of this story?  Most people are insuring their $50,000 lives for $30,000 because some “needs analysis” calculator told them they only “needed” $30,000.  A person’s Human Live Value is the only way to figure out the insurance “need” and so for many, that means using a combination of whole life and term insurance since most can not buy their HLV in all whole life at the outset.  There is nothing wrong with term insurance when it is used for a term of time, is convertible to whole life, and the owner works to convert it slowly over the course of time so that by age 65 or so, it is all whole life.