Be Your Own Lender. Own And Control Your Credit

The Plan

Madeline (age 59) came to me several years ago to talk about her retirement savings.

Up to that point, she had always been told to invest most of her money into a retirement plan of some type. So, for the most part, she did… making substantial contributions to various retirement plans, including 401(k) plans with previous employers and IRAs. Her current employer used a SEP IRA. It didn’t matter. She never seemed to make any headway no matter which retirement plan she used.

When I asked her why she thought she wasn’t doing so well in her investments, she told me she thought the stock market must be some sort of scam.

So… I asked her why she thought it was a scam.

In her own words:

"My only investments were with 401Ks/IRAs I had as an employee. They never grew, no matter what I invested in. I tried everything from Sallie Mae to Microsoft, and the bottom line didn’t budge much at all. I invested in Fannie Mae/Freddie Mac, and you know what happened there! Fortunately my investments weren’t large, so I wasn’t hurt, but I also didn’t get ahead.

"My reason for saying the stock market is a scam is that certain of the top companies control the whole thing and it isn’t a true reflection of value. In my 59 years, it seems to me that everything goes up and down, given natural disasters and government upheavals, and the back-and-forth of having democrats or republicans in office. The market reflects theses fluctuations, but somebody makes a bigger deal out of them than they really are, creating panics and surges that are just going to even out over time. Since I am lousy at predicting the future and determining when it’s a good or bad time to buy or sell, all I can do is drive myself crazy trying to outsmart the market. I don’t believe that’s going to happen with any consistency. 30 years ago, who’d have predicted that Sears would go out of business? Maybe Apple will too when the next big thing comes along. Maybe Boeing won’t recover. It’s all glorified guesswork."

With that in mind, I went to work designing a whole life policy for Madeline which would put her mind at ease about her future savings, while also protecting her in her old age.

I chose a policy underwritten by a mutual life insurance company. Mutual insurers are notable for their low net cost of life insurance and also for the fact that they share profits of the company with policyholders (who are considered owners of the company) in the form of dividend payments. Dividends, while not guaranteed, are generally paid each year and represent surplus earnings as well as savings from death claims and operating expenses.

These dividends typically go towards buying additional single-premium, paid-up, life insurance (which is added to the basic policy), which increases the cash value and death benefit of the policy.

We also discussed some of her other financial goals, which included a few small purchases, and one major purchase…

Her car was starting to show some age and would probably need to be replaced in a few years. Problem was, she had no credit (which banks often consider “bad” credit) and savings which was now locked up in an IRA. So, she faced a high-interest loan from a bank or car dealership unless…

She Used Her Whole Life Insurance As A Method Of Financing Her Next Vehicle

She started her whole life policy by using some accumulated savings as well as monthly premiums paid out of regular income:

As you can see, the first 3 years of her life insurance policy are heavily funded with just over $10,000 of annual premium.

Some of this premium came from personal savings, while some of it came from monthly premiums paid out of income. Her premium purchased $136,671.15 of death benefit and gave her $6,688.50 in cash surrender value. Cash value is the portion of the policy Madeline can borrow against.

In the early years of her policy, the annual returns are negative. Not ideal, but normal for whole life insurance.

The benefits come in the 4th year and beyond:

When it came time for Madeline to buy her car, she borrowed money from her insurance company. This loan is a secured loan which uses the cash surrender value as collateral. Meaning, money never leaves the life insurance policy.

Instead, it continues to grow while she uses the funds for whatever she needs… in this case, a car.

Had she paid for the vehicle in cash, she would have lost interest on that money until she was able to save it up again. By using a policy loan, she was able to buy herself a new (new to her) vehicle without sacrificing her future savings — something she had always struggled with in the past.

Unlike conventional loans, policy loans from a life insurance company are non-amortizing. Meaning, the life insurance company does not require a specific loan repayment schedule. Madeline can create her own repayment schedule.

Because her insurer does not require any principal payment, they only charge interest on the loan. Specifically, interest accrues daily on the outstanding principal balance and is billed at the end of the year.

This little quirk inherent in all life insurance policy loans allows Madeline to repay the principal of her loan during the year before paying interest. Her loan works in the exact opposite manner of every other retail or commercially-available loan. Again, because interest is assessed only on outstanding principal balances, accrued interest will decrease as that principal balance is paid down during the year. And, because of this, it dramatically reduces the total amount of interest paid to the insurance company, allowing her to pay herself the interest which would otherwise go to a bank, credit union, or some other lender.

Madeline’s insurance company also practices a loan method called “direct recognition”. This means when Madeline borrows money against her life insurance policy, the insurance company changes her dividend rate to match the loan rate, in effect giving her the interest she paid on the loan back to her as a dividend at the end of the year. While dividends are not guaranteed, it can help make policy loans an even more efficient method of borrowing money.

In this case, Madeline pockets $1,626.05 in cash — interest which would have gone to a car dealership’s financing arm or a bank. To be clear, this money is not interest she owes to the insurer, either. This is cash-money she pays to herself. She can choose to put this money into her savings account or some other investment. But, instead, she puts this money right back into her whole life policy. By doing this, she will increase her cash value and thus the amount she can borrow in the future.

She can repeat this process an infinitenumber of times, creating her own “bank” of sorts from which to finance major purchases.

She Also Finances Her Own Premiums

Once Madeline understood the basic concept of financing major purchases through whole life insurance, I suggested she finance her own monthly premium payments.

Every insurance company — auto, home, life — charges a finance charge for paying monthly. This finance charge is the cost of doing business with the insurance company.

Finance charges exist because premiums are technically due in advance (before the insurer will agree to provide coverage). However, most people cannot afford to pay for insurance in advance, so… the insurance company agrees to finance the monthly premium.

But… Madeline can do better than the insurer’s standard offer.

She uses a little-known option embedded in her policy contract called a “premium loan.” Premium loans are part of the basic loan provisions of the policy. It allows her to finance her own premium at a lower rate than the standard rate offered by the insurance company.

So… we switched her premium payment method to premium loans:

Madeline’s basic premium for this policy was $338.00 per month ($4,056/yr). By financing her premium, the insurer agrees to eliminate the normal finance charge, reducing her premium to $3,889 per year.

Then, she agrees to repay the premium loan over the next 12 months. But, when she does so, she recognizes the actual cost of that premium. In other words, the insurer was charging her $167 per year as a finance charge to spread out the annual premium into 12 monthly payments ($4,056 – $3,889 = $167)… so, she repays her premium loan with the same amount she was paying when she paid premiums monthly.

Of course, the insurer charges loan interest on premium loans, just like any other policy loan. But, the interest is much less than the finance charge for paying monthly premiums, allowing Madeline to pocket ~$70 every year — money which would have gone to the insurer as a finance charge, but which instead can be paid directly into her policy to increase the cash surrender value for future borrowing.

This method of paying premiums grows the cash value more quickly than if she had paid the insurer a premium finance charge. It also saves her insurance company some money on processing monthly payments — both her and the insurer win.

And the net result is her policy is more efficient and costs are reduced, improving the growth of her cash value.

Each time Madeline needs to make a major purchase, she chooses to finance it through her life insurance policy. She can grow her savings through systematic borrowing and repayments, thus controlling her own financial future. Today it’s a vehicle, but tomorrow it could just as easily be something else — financing a new computer, a vacation, or she could start a part-time (or full-time) business if she chooses, financing everything she needs through her whole life policy.

But… even if she takes no other policy loans, both the guaranteed and the non-guaranteed cash value of her policy is projected to grow each and every year.

Her policy also allows her to permanently stop making premiums whenever she retires (whatever age that may be). For example, if she elects to stop making premiums at age 70, her whole life policy converts to a paid-in-full (reduced, paid-up) life insurance policy. Her death benefit is slightly reduced, she keeps all of her accumulated cash value, and she never has to make another premium payment for as long as she lives.

Now She Has More Control Over Her Future

Madeline was thrilled to see just how efficient this process was, and is excited about future opportunities to use her policy’s cash value.

She has dramatically improved her financial situation. She no longer needs to worry about borrowing money for major (or even minor) purchases. Her cash surrender value was originally projected to be roughly $73,000, but because of her willingness to self-finance her vehicle, she is now projected to have a cash value of over $76,000 by age 70.

Self-financing has allowed her to grow her savings at a more predictable rate, and do it efficiently and without a lot of stress. Regardless of future dividend rates (which cannot be known), she feels she has more control over her future. This is something financial planners generally cannot promise and, because of that, it's something most investors don't have a deep appreciation for.

When she retires, Madeline can draw on the policy’s dividends for income or take policy loans to supplement Social Security and her retirement account income.

She also has some protection against extreme old age because her whole life policy includes a special chronic illness rider, which allows her to spend her death benefit before she dies if she suffers a permanent chronic illness or needs long-term healthcare services. Her chronic illness rider is not long-term care insurance, but does provide a generous benefit if she needs to pay for long-term care expenses.

Most of all, she feels she has more control over her finances and her future than she ever did before.

Again, in her own words:

"I borrowed the funds for the purchase from myself (the equity in my policy) and am repaying it at interest, without the hassle of negotiating with car dealers who do their level best to confuse little old ladies like myself. That interest goes right back into my policy value. So yes, I am paying myself for purchasing a car. What could be better? I have used this method several times, even when I had funding to purchase something outright, because the interest I am paying myself increases the policy value. The more I’m able to do this, the more security I’ll have upon retiring."