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.