If you’re at all familiar with whole life insurance strategies, you may think it’s possible to get ahead while carrying a loan balance. We won’t say it’s impossible (especially with the right strategies), however, we would challenge you to think a little bit deeper about the numbers at play.
Let’s say your clients are earning about 6% net in an account, and they take a policy loan at 8%. You may, at first, think that it’s obvious that they won’t be able to get ahead. However, there’s a common misconception that you can (and should) get ahead with a loan. After all, some people may sound convincing when they suggest that with an increasing balance at 6% and a decreasing balance at 8%, you’ll come out on top.
So let’s take a more in-depth approach and get to the whole truth.
Can You Get Ahead with a Loan Balance?
Take a $100,000 account earning 6% over 20 years. The Future Value is going to be $320,714. In other words, the account earned a Net of $220,714 in interest over 20 years.
Now let’s look at the loan. First, we’ll need to use a Payment Calculator to figure out how much the client is paying towards the loan each year if they’re paying it in 20 years. In order to get comparable numbers, we’ll assume the loan is at the same value $100,000-with an interest rate of 8%. As you can see below, the annual payment is $10,185.22.
In order to see what that interest cost would be, we can simply multiply that by 20 years and subtract the hundred-thousand, right? If we did so, the total loan cost would be $203,704 and the total interest would then be $103,704. This interest cost is much less than what the client earned on their $100k at 6%. So that’s where the calculations end, right?
Unfortunately, this IS where most people end their calculations. However, all the facts are not present.
The Missing Facts
In reality, the only way to make valid financial conclusions is to make both sides of the equation completely equal in all regards. This includes the cash flow.
Considering that, in order to have an equal comparison, the $10,185.22 cash flow must be accounted for on both sides. This begs the question: what if you used the $100k account (the one earning 6%) to pay down the loan in one lump sum? Then, your client could apply that $10k a year to their account earning 6%.
If you do that, the 6% account would grow to $374,669 over 20 years, instead of the original $320,714. So, by doing this, the client pays no interest on the loan, and they come out on the other side with $54,000 more in the “bank.”
So while it is true that we pay less interest ($103,704) than we earn ($220,714), that is only part of the truth. The whole truth is that the cost of money does matter and in the above example, the client’s costs are greater than their gains. This is the whole truth, even though we earned more interest than we paid out in interest. There is a $54k improvement by paying off the 8% loan with the 6% account and redirecting the freed-up payments to the investment.
The Issue of Liquidity
One critical issue left over is liquidity. Obviously, $100,000 in an account leaves your client in a more liquid position initially than an annual contribution of $10,185.22. Yet eventually, those contributions will surpass the original $100k.
If initial liquidity is a concern, it may be worth giving up some of the $54k improvement in order to be in a more liquid position. You can work with the client and their specific financing concerns to determine how much of the initial $100k they’d feel comfortable contributing to debt service. From there you can calculate the new annual loan payment and subtract it from the $10k contributions.
An additional consideration is: how is the client using the loan? For example, if that $100k loan is destined for a cash flowing investment (like a rental property), you may decide to structure things differently. In that case, it would be in your client’s interest to do some calculating. In the end, maybe you choose to keep the $100k liquid and use the cash flow from the property to pay the loan balance. Or, maybe you choose to pay down the loan in a lump sum, and contribute the annual $10k AND the cash flow from the property to the 6% account.
The point is that there isn’t a right way or a wrong way—there are many paths your client can take, and the best path will differ from client to client. Everyone has different desires and wants to accomplish different objectives with their money. However, you can’t give your client their best options if you don’t have all the facts.
To learn more about finding the whole truth, we recommend attending one of our annual Truth Training events. You’ll learn how to take your financial calculations further, so that you have all the facts.