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.