The ability to leverage has always been intriguing. Borrowing money to pay the premiums for life insurance is no different. The concept of premium finance can be somewhat overwhelming; however, if separated into its component parts, it can be a simple topic with great opportunities.
What makes premium financing complicated is it is really a combination of three separate transactions. The first transaction is the lending transaction, the second transaction is the life insurance approval process, and the third transaction is the collateral requirement. Each component can be broken apart so that each step is easier to understand.
In the lending transaction, the primary issue is the interest rate. The interest rate can be fixed or variable, both of which can be attractive options depending on the risk profile of the borrower. Fixed rate loans will have a built-in premium since the risk of increasing rates has been shifted to the lender. If a private lender is a “related party” as defined in the internal revenue code, the interest rate must satisfy the tax rules for minimum interest rates between related parties. In today’s low-interest rate environment, interest rates can be very attractive, but we know all good things will come to an end and interest rates will eventually rise.
The second transaction of the premium finance concept is the underwriting of the life insurance. This step will be subject to the underwriting guidelines of the life insurance company and may have additional requirements to satisfy due to the financing arrangement being utilized.
The third transaction involves the collateralization to secure the loan. Typically, the primary collateral will be the cash surrender value of the life insurance policy. In the early years of the policy, there will most likely be a shortfall between the outstanding loan balance and the cash surrender value, and this shortfall will almost always need to be covered by liquid collateral depending on the requirements of the lender. The guidelines of the lender will dictate the type and amount of collateral to secure the loan.
The final piece needed in the premium financing concept is the exit strategy. Since this is a leverage strategy, there will need to be an end to the borrowing arrangement. The exit can be either at the death of the insured or before death. The death benefit of the life insurance policy will typically be grossed up to pay off the lender and have the necessary death benefit going to the designated beneficiary of the policy. However, the borrower should have an exit designed in the event the loan is to be paid before death. The exit could include paying back the loan with money outside of the financing transaction or could include some of the cash surrender value growing inside of the life insurance policy. Whatever the circumstance, a plan to unwind the financing portion of the plan in the event of changed circumstances or even planned events will ensure that the client’s goals can be achieved.
If you have questions regarding premium financing, I encourage to you schedule a complimentary phone consultation with a Camas Wealth Advisor.