What is the best option for you to have success with your Infinite Banking policy?
Will one option ruin your plan from the beginning?
This is a common topic for someone new to the Infinite Banking Concept to spend hours researching. The first thing you should know is the only thing this refers to is whether or not a life insurance company recognizes the fact you have a loan outstanding.
A short review of how borrowing works with policy loans.
The first thing is you need to pay premiums into your policy to create cash surrender value. You CANNOT take a policy loan without cash surrender value.
If you have done this and need to borrow money from the life insurance company for any reason, you can take a policy loan. When you take a policy loan, what is actually happening is the life insurance company is giving you a loan from their general account, which they charge you interest for. During this time, the premium you paid to your policy stays in the policy, continuing to earn guaranteed interest and dividends if declared by the company.
Your cash value is serving as collateral for the loan however. This is why on an illustration you may see a net cash surrender value column showing that your cash value dropped when you take a loan. It’s what you have access to net of the loan. If there was a gross cash surrender value column (there isn’t), you would see ALL the cash surrender value still in the policy.
It’s important to remember you borrow from the insurance company and pay the insurance company interest, not yourself.
Okay, so where does direct recognition come into play?
With this type of policy, the insurance company will directly recognize the fact you have a loan outstanding on your policy.
This means the insurance company will adjust the dividend rate on the portion of your policy that is collateralizing the policy loan. Any cash surrender value that isn’t collateralizing the loan will continue to receive the declared dividend rate of the company.
ONLY the collateralized value of the policy will have the dividend rate adjusted.
Now, this does not mean the dividend rate will be reduced or increased. Each company has their own specific treatment, and depending where the interest rate for policy loans is set compared to the dividend rate will also play a role in determining this.
Here are 2 examples.
- Let’s say a company has a dividend rate of 5% and a loan interest rate of 6%. The dividend rate can be adjusted up to 6% on the collateralized cash surrender value (the loaned value) and stay at 5% on the remaining cash surrender value. In this case the dividend rate was adjusted up.
- Now let’s say the dividend rate is 6% and the loan rate is 5%. The dividend rate may be adjusted down to 5% on the collateralized cash surrender value and stay at 6% on the remaining cash surrender value. In this case the dividend rate was adjusted down. (These examples are just meant to show what could happen when a loan is taken with a direct recognition company and aren’t representative of any company. Each company will have their own method to determine the adjustment. I did make them realistic to actual real-world application of direct recognition though.)
With this type of policy, the insurance company will not recognize the fact you have a loan outstanding.
This means that all cash surrender value, whether collateralized or not, receives the same dividend rate.
Here is an example.
Let’s pretend the dividend rate is 6% and the loan rate is 5%. When you take out a policy loan the company continues to pay you the 6% dividend rate on all your cash surrender value, both the collateralized portion and the non-collateralized portion, there is NO adjustment made.
*For those of you thinking this means you’re making money on the spread of this, remember there are 3 factors that go into determining the crediting rate to your cash surrender value. The dividend interest rate, mortality experience of the company, and cost of operation. This means your earning a rate less than the GROSS dividend rate (6% in this example).
Fixed and variable loan rates.
Fixed loan rates are typically higher than variable loan rates in today’s environment (this has the potential to change in the future).
Fixed loan rates are fixed for the life of the contract, although some companies will do an adjustment of this rate at a certain age, like 65 for example, to help when a policyholder wants to take passive income. You would know this information up front.
Variable loan rates can be adjusted 1 time a year. Here is an example from a policy I own stating how the legal maximum interest rate is determined for the variable loan interest rate:
The legal maximum interest rate used in determining the loan interest rate is the greater of:
(a) Moody's Corporate Bond Yield Average— Monthly Average Corporate as published by Moody's Investors Service, Inc. for the calendar month ending two months prior to the date as of which the loan interest rate is determined; or
(b) the interest rate used to calculate cash values under this Policy during the period for which the loan interest rate is being determined, plus 1%.
This is how the rate is adjusted:
1. If the legal maximum interest rate is lower than the loan interest rate in effect during the preceding calendar year by ½% or more, the loan interest rate will be lowered to be less than or equal to such legal maximum interest rate.
2. If the legal maximum interest rate is higher than the loan interest rate in effect during the preceding calendar year by 1/2% or more, the loan interest rate may be increased by at least 1/2%, but not to exceed the legal maximum interest rate.
If you have a fixed loan rate you have to have direct recognition, but direct recognition can have fixed or variable loan rates.
Why is that?
Think, if you have a fixed interest rate of 6% and the life insurance company’s general account is earning 12%, the life insurance company can adjust your dividend down on the loaned portion.
If they couldn’t do that, what would happen?
Let’s take a couple steps back. If you don’t have the money in your policy loan, the insurance company would have it in their general account and it would be earning 12%. You also must remember that profits are shared between the policyholders with mutual companies. If you have money out on loan at 6%, the other policyholders would basically be sharing their portion of the dividend with you because the policy loan isn’t earning as much as the general account. That is why a fixed interest rate must be direct recognition, it keeps it fair to every policyholder because the company adjusts the dividend.
So, what is better?
Ultimately it doesn’t matter in the long run. They work differently, but each get us to the same place in the end. Personally, I own both.
Direct recognition is actually the fairest, and here is a short explanation of why.
All non-direct recognition policies that I know of have a variable loan interest rate. The insurance company will keep the loan interest rate close to what the general account is earning. It is very possible though that the account could be earning a higher return than the policy loans before an adjustment is made. In this case, everyone who didn’t have a policy loan would be subsidizing those that did with their dividend. Everybody got a smaller dividend in this case.
Direct recognition is less sensitive to this.
Finally, this is not a problem to be concerned about, and just remember that there is NO FREE LUNCH with either system of loan recognition.
What you really need to understand. Remember this.
The Infinite Banking Concept is about controlling the banking function in your life! Both of these contracts allow you to do this.
My mentor, John Montoya, asked Nelson Nash about loan recognition and was told by Nelson, “Now son, you’re majoring in the minors.” This simply means you’re getting caught up in something that is incidental in the process of becoming your own banker.
Both systems will fit you very well and if it is something you’re really bothered by; you can own both! Remember when you truly practice the IBC, you’ll have a system of policies, not just one.
Book Your IBC Discovery Call today if you have questions or are ready to take action.