In Retirement planning, variable Loans are common options in life insurance policies and are used when people are looking to borrow money from their policies. However, there is no way to determine whether the money left in the policy will continue to make money or if an individual will be forced to obtain funds to cover the interest charges for the loan. There are other options, including a policy that credits 140% of the annual returns of the S&P 500.
Variable Loan Options when Planning for Retirement
Read Part 1 Cash Value Life Insurance
Variable Loans Within Cash Value Life Insurance
Variable loans are available with many policies from a variety of companies. These are usually used to enhance a product as well as the potential for a larger loan that would be tax-free for individuals who own a policy. In short, the company would continue to charge interest at a current rate on any money that is borrowed from the policy. For the sake of argument, we will say the rate is 5%. If the policy holder were to use a wash loan, the policy would be credited the same rate, 5%. When using a variable loan, the return on the investment will be unknown as it will constantly change, hence, the word ‘variable’.
Example of Equity Indexed Life Insurance Return
Let’s say an individual buys an Equity Indexed Life Insurance (EILI) and the growth that is in the policy is correlated to the S&P 500. Should the year produce a return of 11% on a policy that charges an interest rate of 5%, the policy holder would actually make money by borrowing from their policy.
Things change if the S&P 500 has a negative return for the year. In this case, the interest rate would remain at 5%. If the S&P 500 does not perform better than the interest rate, the cash that was left in the policy would be used to pay the cost of the interest on the loan. This results in the policy holder losing cash value inside the policy.
Example of Variable Loans Return
If the policy holder had been using a variable loan when the S&P 500 returned a negative amount, it is possible the individual would have heard from the insurance company stating that there are not sufficient funds in the policy to cover the cost of the interest. Another possibility is that the policy would lapse.
Insurance Companies Show Variable Loans Instead of a Wash Loan
Unfortunately, individuals who purchase a policy that has the option of a variable loan often do not understand why this option even exists. These policy holders only look at the amount that can be borrowed from the policy and do not consider the ramifications.
The problem is that the software that is used to display the loans’ forecast will default the interest on the loan. They will display the numbers for a variable loan instead of a wash loan. This can include a spread of 1-2%. The reason the variable loan is used in the software calculations is because, historically, the S&P 500 has always performed better than any interest rates by at least 2% each year. Even though this is the average, there is always the possibility that the S&P 500 could underperform. It happened in the 1980s where interest rates were over 15% at some point. During times like that, the policy holder would be in a world of hurt with a variable loan if the S&P 500 took a dive or went flat over an extended period of time.
Disclosure of a Variable Loan and Wash Loan
If you are even contemplating buying a policy with a variable loan option, you must make sure you have a complete understanding how the loan will work if you ever have to borrow against your policy. Make sure to get an output of the variable loan as well as a wash loan and take the time you compare the numbers. Even if the agent pushes a variable loan option, you should be aware that you have two choices available; the variable loan and a wash loan. Many agents will not disclose this information, so it is up to the individual to do some homework.
Equity Indexed Life Insurance Can Credit 140% of the S&P 500 Returns Every Year
It has been mentioned that some EILI policies will credit the policy holder with 140% of the return of the S&P 500 for the year. This is the type of policy that is preferred when dealing with a variable loan. To help you understand why this is a good choice, let’s set an example to make things clearer.
We will assume that a policy has an interest rate of 5%. Most policies will be pegged to the returns of the S&P 500, which let’s assume in a particular year is around 3.7%. In this case, the policy holder will be negative 1.3% because the return of the S&P 500 is less than the amount of the interest. This is why policy holders would benefit more from a wash loan. It protects them from the possibility of the S&P 500 underperforming the interest rate and reduces the chances of losing money when taking a loan on a policy. If the policy holder had chosen a wash loan, the policy would be credited with 140% of the S&P 500 returns and the individual would have earned 5.2% in the policy instead of losing 1.3%.
To change the numbers, let’s say the S&P 500 returned 2.5% for the year. The individual would then be negative 2.5% if the interest rate remained at 5%. However, if the individual had a policy that credited 140%, the loss would only have been 1.5%. This can amount to a huge sum of money.
Added protection is awarded to a individual when they have the 140% credit. At some point, the S&P 500 will underperform. There is never any way to know when this will happen, so in order to protect against huge losses, individuals would benefit from choosing a policy with the extra credit. In addition, the same type of policy will provide a no lapse guarantee for individuals over the age of 65.