As we saw in permanent life insurance explained, the benefit of investing in these policies are their living benefits in form of a cash value that can produce tax free investment returns and serve as a security for flexible loans.
The proper understanding of the value of good debt is one of the things that separates the mindset of the wealthy versus the rest.
The wealthy knows that when loans are used to invest in projects with a positive cash flow, it is a powerful tool to create and expand wealth at a faster rate and bigger scale that without loans.
As long as loans carry a positive cash flow and are controlled by good risk management, it is one of the most powerful tools of building wealth known to man.
Contrary to popular belief that it is good to be free of debt, in reality the only debt that should be avoided is the debt that carries a negative cash flow.
In this article, we are going to go through how life insurance loans works and how it can help you multiply your portfolio.
This article is written as general education, and should not be considered as personal financial advice. If you would like personal guidance with life insurance, you can schedule a time to talk with one of our experts.
What are life insurance loans?
Because of the stability of permanent life insurance, once cash value has been funded in the policy, can be used as collateral in a loan, just like a house can.
When the loan is taken at the time of signing up for the policy, similar to taking out a mortgage while buying a house, it's called premium financing.
Premium financing is a good way to put less cash towards your insurance policy while still being able to build a higher cash value.
When the loan is taken during the lifetime of the policy, similar to a home equity loan while owning a house, it’s called a policy loan.
The benefits of these loans are plenty - they carry a low interest, they require no credit checks and they are quick and flexible.
The flexibility of these loans means that they don’t necessarily need to be paid back every month, as long as the loan balance is less than the cash value.
This flexibility allows the loans to be safe during potential future cash flow difficulties, although for optimal financial results it is important to pay back the loans appropriately.
Multiplying your portfolio
When using policy loans to finance investments, money can be put to work at two places at the same times, and higher returns can be achieved at an additional risk.
These loans can be used to fund investments like stocks, bonds, real estate, business projects, or anything else that could give a return on the money.
However, not all loans will provide a positive financial effect. This is why it is important to understand the difference between a positive and negative cash flow loan.
As long as the investment that the loan is funding is generating revenues that are bigger than the interest, the loan will be cash flow positive, and will put extra money in your pocket every month.
The higher the returns, the higher the profit, but equally important is the dependability off those returns.
This type of debt is a good way of leveraging your money as a means of increasing your returns and available investment capital.
Remember, the money taken out as a loan is still left inside the life insurance policy, growing at a safe and dependable rate, while its loan representative is being invested elsewhere.
If the returns of the investment is less than the interest, the loan will be cash flow negative, and will imply extra costs.
It will be better than if the loans were just used for consumption, but it is not a desirable loan to maintain, as it now is a liability that takes money out of your pocket rather than putting money into your pocket.
To avoid these loans, make sure that the money you take out as a loan are being put to productive and secure use, and if an investment starts performing worse, be prepared to cut your losses and move on.
Risk management for loans
The risk associated with the loan is tied to your type of life insurance policy, your investment, and how high you keep your loan balance in comparison to your cash value.
To handle the risk of endowment loans, they are best executed through universal or whole life insurance, as the cash value can not decline with those policies.
By using a life insurance policy with downside protection, you remove the risk of the policy lapsing due to a decrease in your cash value.
The risk of having collateral decrease in value is exactly what caused so many foreclosures in 2008, when many people had mortgages that were foreclosed as the value of their real estate fell below the value of the loan.
When it comes to choosing an investment object for the loan, it is important to not only consider the potential returns, but also the potential risks.
For the most secure results, the returns should be associated with bonds, as the coupon payments on bonds are legal obligations.
For more risk and potentially higher profits, the returns could be associated with dividends from investments like stocks or real estate, but this strategy carries a higher risk as the dividend of a stock is not a legal obligation.
The most risky type of loan is where the returns are associated with an increase in the value of a security, as this is the least dependable category of investment returns.
This should only be practised by the experienced, and requires more active maintenance but could yield the highest returns.
This could be things like an angel investment, a day trading account, or a fix and flip strategy for real estate.
Finally, it is important to monitor the size of your outstanding loans in comparison to the size of your cash value.
A more conservative investor would want to maintain their outstanding loan balance under 50 % of the cash value.
A more aggressive investor might consider keeping their loan balance between 50 to 90 % of the cash value.
However, anything above 90 % is a clear risk zone, where a lack of loan payments could risk losing the whole policy.
In the worst case scenario, if the owner is unable to pay back the loans, and the loan balance exceeds the cash value, the policy will lapse.
A policy lapse means that your life insurance policy goes out of effect, and you will be taxed on your gains as if it was an ordinary investment.
This is not what you want to achieve. The best way to use permanent life insurance is to hold it until you die.
The best way of leveraging this strategy on a scale is to build a portfolio of life insurance investments, and use the total cash value as security for loans.
Policy loans is a powerful tools to multiply the returns of a portfolio by using them to fund investments like bonds, real estate, stocks, or business projects.
They do however require risk management, which mainly consists of using a cash value with downside protection, invested with a secure and high enough return, and keeping the loan balance lower than the cash value.