Life insurance companies charge interest when we borrow their money just like banks and credit unions and other financial institutions do. While many advisors outside of our sphere make statements suggesting we borrow our cash value, or that there is some special magic to life insurance loans, this is ultimately incorrect.
The whole truth is we borrow against our cash value, or to be more specific we borrow the insurance company’s money and use our cash value as collateral. The companies can 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, and at the same time their cash value keeps growing. This gives all the other policyholders peace of mind because they know the insurance company is investing properly since the interest is reflective of the marketplace (yet NOT subject to).
Marketplace Interest Rates on Life Insurance Loans
Some companies charge a fixed rate, some charge a variable rate. Some have both available due to the direct recognition method.
There are two different methods insurance companies use to handle the loaned cash value — direct recognition and non-direct recognition. In a non-direct recognition company, the earnings rate on cash value is totally unaffected by any loans against cash value. In a direct recognition company, the earnings rates on loaned cash value are affected (both positively and negatively) when the cash value is used as collateral.Direct Recognition Contracts
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, 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. In the span of decades, the difference between non-direct recognition companies and direct recognition companies is pennies. Better to have life insurance in force than to deliberate between the two methods. Maybe consider having both!
Where Does Interest Charged Go?
The interest charged by the insurance company goes to the insurance company, not to your policy directly. There is a common misconception that when you pay the interest on your policy that you’re “paying yourself interest.” This is not the case. When you borrow dollars from the insurance company, it comes out of the insurance companies’ investment pool and therefore they need to charge an interest rate for it to replace the interest they would have lost if it had stayed invested.This interest does not add to your cost basis or directly increase the policy’s cash value that is being collateralized. However, the earnings of the life insurance company (both from their investments in the marketplace as well as their investments in policy loans) are what they use to pay dividends to all policyholders. Therefore, it benefits you in the end to pay that interest.
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. This is what is really happening when advisors suggest “paying yourself interest,” yet we find that the imprecise language causes too much confusion, and prefer not to frame it that way.
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.
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