Premium Finance

In today’s financial landscape, it’s common to encounter agents or brokerages advocating for premium financing to boost life insurance coverage. It seems like an attractive proposition, offering more protection without a hefty price tag. However, there’s a catch. When you rely on borrowed funds, there are always associated costs. It’s essential to thoroughly understand these costs upfront. Otherwise, you may find yourself disappointed, like chasing a rainbow only to discover coal instead of the promised pot of gold.

The Temptation and Reality of Premium Finance

Premium financing appeals to individuals seeking something for nothing, akin to expecting the Golden Gate Bridge to accompany a purchase. However, reality dictates that everything comes at a cost. As renowned economist Milton Friedman asserted, “There is no such thing as a free lunch.” This principle remains valid today. Economic laws, as articulated by Friedman, persist unchanged and show no signs of alteration.

How Premium Financing Works

Premium financing typically involves offering collateral to secure a loan for purchasing a life insurance policy. Depending on the type of policy—universal life or whole life—the policy’s cash value or paid-up life insurance should ideally exceed the initial loan over time. Options emerge at this point: cashing in the policy to repay the loan or borrowing against the cash value to settle the original debt. Consequently, you retain a life insurance policy purportedly worth more than your initial investment.

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The Catch: Taxes and Double Interest

If you opt to cash in the policy to settle the loan, be wary of potential tax implications. You may owe taxes on the disparity between your premium payments and the accumulated cash value—a hidden expense to watch out for.

Alternatively, borrowing against the policy entails paying interest twice on the same funds, akin to borrowing from your IRA or 401k. While you repay with interest, it’s from after-tax dollars. Upon retirement, when you withdraw from your IRA or 401k, you’re taxed again. It’s a financial déjà vu that could prove costly in the long run.

Paying interest once is burdensome, let alone twice, and facing multiple taxes on the same dollar is undesirable. Given these drawbacks, why would anyone entertain premium finance for life insurance? It’s a question deserving thoughtful consideration.

Beware of the Brokerage Pitch

Here’s why some individuals are drawn to premium finance: Imagine an agent or brokerage persuading you, your business, or your family to invest in a substantial cash value life insurance policy. Initially enticing, right? But here’s the twist: They propose borrowing from that policy after a year or so to initiate another one, repeating this cycle with additional policies. Termed “laddering” or “stacking,” it essentially entails using borrowed funds to finance more policies, regardless of your financial comfort. The catch? Accumulated interests and premiums could pose significant challenges in the future. By then, the agent or brokerage may have moved on, leaving you to deal with the consequences. It’s akin to being abandoned while they chase their next big idea.

The Reality Check: Policy Lapses and Financial Headaches

Examining the facts reveals a clear pattern. Initially, policy one’s $10,000 annual premium should generate enough cash value to kickstart policy two in the second year. By the fourth year, policy two should ideally have sufficient cash value to fund policy three, creating a domino effect.

However, the reality is harsh. By year three, policy one often depletes its cash value, necessitating an additional $3,548.91 to prevent lapsing. Even if you start a smaller second policy with just the paid-up insurance rider premium dropped from the first policy after year one, policy one’s cash value vanishes by year eight. This leaves you liable for interest costs and potentially taxes on lapsed policies, plunging you into financial distress. It’s distressing to face tax obligations for income you haven’t realized or benefited from beyond paper claims.

The Smart Money Moves

Life insurance premiums decrease notably with larger investments due to the fixed annual fee in participating whole life insurance, unlike in universal life policies where it’s a percentage of your premium. Additionally, premiums are lower when you’re younger. Therefore, it’s wise to invest the largest comfortable premium in any participating whole life policy. Skipping the paid-up additional insurance rider and purchasing more permanent insurance with those funds can be advantageous, given that coverage costs rise with age. Ultimately, opting for life insurance through premium finance doesn’t align financially or in the long term.

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Protecting Yourself – A Checklist

To safeguard yourself from premium finance broker/dealers prioritizing commissions over your interests:

1. Stick to Your Budget: Invest only in affordable life insurance policies.
2. Trust Your Instincts: Reject uneasy insurance products.
3. Be Wary of Leveraging: Caution against using one policy to fund another.
4. Pay Interest from Income: Cover loan interest with regular income.
5. Understand Costs: Recognize borrowing costs before leveraging.
6. Invest Borrowed Funds Wisely: Offset interest costs and maximize returns.
7. Avoid Loaned Premiums: Don’t use loans for premiums without repayment plans.

Following these steps prevents tax issues and ensures future premium affordability, securing financial protection. Building wealth requires patience, knowledge, savvy, frugality, and productivity, not quick fixes.

Prioritizing Long-Term Stability

Leveraging the cash value in life insurance isn’t a magic bullet for overnight wealth. It’s a method grounded in sound money management principles that can gradually bolster your financial well-being over time.

The key is to adhere to a pace that feels comfortable and sustainable for you. Rather than chasing after quick gains, focus on steady progress. By doing so, you’ll find yourself retaining more of what you earn and avoiding the pitfalls of impulsive financial decisions.

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It’s crucial to understand that financial success isn’t about taking shortcuts or seeking instant gratification. Patience and prudence are the cornerstones of making sound financial choices, whether it’s leveraging life insurance or exploring premium financing options.

Rushing into decisions without fully considering the long-term implications often leads to more trouble than it’s worth. Instead, prioritize informed decision-making and staying true to your financial goals. By focusing on building wealth steadily and responsibly, you’ll pave the way for lasting financial security and peace of mind in the years to come.

Dr. Tomas P. McFie

Most Americans depend on Social Security for retirement income. Even when people think they’re saving money, taxes, fees, investment losses and market volatility take most of their money away. Tom McFie is the founder of McFie Insurance which helps people keep more of the money they make, so they can have financial peace of mind. His latest book, A Biblical Guide to Personal Finance, can be purchased here.