Certainly, there is no shortage of financial minds out there who shout from mountain tops that whole life insurance is the worst investment known to man, inappropriate for all. For the most part, I would agree with them.
However, for the right individual, it can function, not as an investment, but as a particularly versatile financing vehicle, that when combined with the right investment strategy, the overall performance is quite compelling. While it is true that it takes years for a policy to generate even modest returns on premiums paid-in, the cash value builds on an income-tax deferred basis and can serve as a handy source of tax-advantaged liquid capital.
My promise: At no point, in this article, will I attempt to convince you to buy a whole life insurance policy and implement the same strategy. It’s not for everyone, so no need to force the issue. As many have inquired about certain line items in my Net Worth schedule pertaining to whole life insurance, I am simply laying out the mechanics and numbers, as requested. No chest-pounding.
Your promise: To keep an open mind, nothing more. In the end, we all have the same goal in mind – financial independence. It shouldn’t matter how each one of us achieves this goal, only that we get to join everyone at the party, right?
And without further ado…
CORNERSTONES: POLICY GROWTH & LOAN FEATURE
Ever since I was 23 years old, I have been saving money in numerous whole life insurance policies (the mattress). Every month, I make mandatory premium payments in exchange for stable growth (cash value) and the promise, but not the guarantee of dividends.
The insurance company, a “participating” company (i.e. dividend paying), must also be a non-direct recognition company. Being both participating and a non-direct recognition company is extremely important to me because the earnings rate on my cash value is completely unaffected by any loans I take. Once the cash value has built-up, I am able to access the loan feature to serve as a penalty-free and tax-free source of liquidity for emergency use and/or investments. You read correctly, I have access to the premiums paid in, penalty-free and tax-free. Conversely, a direct recognition company will pay a dividend off the cash value less any outstanding loans, as illustrated:
Jumping Jehoshaphat! How can this be?
When I borrow money from my policies to make an investment, I am not withdrawing funds from the policy, itself. The insurance company is the one who is lending me money and holds the cash value in my policies as collateral. Non-direct recognition companies will continue to ‘recognize’ and pay dividends off the total cash value amount.
This is referred to as the Multiple Uses of a Dollar technique, whereby a dollar earns for you, concurrently, in two or more places.
Now think of selling stock in order to fund the down payment for a rental property. Will the company of the issued stock continue to pay you dividends? Absolutely not, which means the dollars can only be working in one spot at a time – the stock or the rental property, but not both.
It’s perfectly normal. It took me 10+ years to get to this point and I am still learning new things. I helped educate myself by drawing it all out and will do the same in the next section. I believe most people benefit, regardless of perceptual preference, when writing and illustrations are combined.
THE STRATEGY: LEVERAGING SIMPLE INTEREST TO INVEST
Within my Net Worth, I have a liquid asset labeled Life Insurance Cash Value and a liability, reducing my assets, called “Other”. In this line item are loans I have, with the non-direct recognition insurance company, funding various investments.
Because the loans from the insurance company are charged at a simple interest rate. Simple interest is called simple because it ignores the effects of compounding – i.e. interest on top of interest. Interest Rate x Outstanding Loan Balance (each annual anniversary date of the policy) is the formula, nothing more. Can you name another loan out there that applies a 100% of a repayment to the principal before calculating interest? This is made possible because the cash value, held as collateral, is constantly growing each year. The insurance company is, therefore, able to offer such favorable terms knowing the compounded growth will always exceed the simple interest.
So what do the loans in my Net Worth represent?
STEP.1: Borrow. Invest. [Illustration-1]
Even with stable growth, I do not view my policies as investments. I analogize them to any other financing vehicle, waiting to deploy capital to the right investment. For purposes of this post, I will use my account with the real estate crowdfunding platform, PeerStreet. PeerStreet is a unique online community whereby investors pool their money together into a single investment property, while maintaining direct ownership and earning monthly interest. Borrowed from the life insurance company at a 4.40% simple interest rate and invested, as illustrated:
STEP.2: Profit. Reinvest. Repeat. [Illustration-2]
My portfolio of investments in PeerStreet are earning compound interest at an average rate of 8.50%. Since there is no monthly principal and interest payment to be made on the loan, only annual interest, I have the following three options available with respect to the monthly earnings:
1) If the monthly PeerStreet earnings accumulate such that I meet the minimum investment threshold, I reinvest immediately and continue the compounding.
2) Transfer the earnings in the my PeerStreet cash account to my savings account and get it compounding again. Albeit, a measly 0.50% rate, but always compounding until the minimum is met to be redeployed back into another investment property.
3) Pay down the loan principal amount, reducing the interest payment due next year.
STEP.3: Simple Interest Payment. [Illustration-3]
I’ve built a cash flow forecasting model in excel that shows me each month’s earnings and when principal is to be repaid. I leverage this tool to know which investments will not be reinvested so I can take the earnings and returned principal to service the interest on the loan. Eventually, the compounded returns will outpace the simple interest and begin to pay down principal on the loan.
Again, this is just a very high level view of how this loan strategy works (for me) and many points had to be considered before implementing. I have made all numbers transparent so that you can run them yourself. The math is what it is. Once I understood the mechanics, the hardest part was finding an investment with the right risk profile and return metrics.
It’s chaotic, complex and by far the ugliest baby out there…but it’s my baby. Most will only be able to point and stare in horror, but for the right individual, they will be able to see the beauty – liquidity.