In a previous post, Nuwire writer Eric Ames profiled “The Infinite Banking Concept“. This was a followup post to an article titled: The Infinite Banking Concept: Be Your Own Bank. I’d like to provide a fresh perspective on this concept, because I believe that it’s being overcomplicated by many well-meaning advocates.
What Is The Banking Concept?
The banking concept is probably at least 150 years old, although there are some new-age marketing names and gimmicks associated with it today. If you search for “Infinite Banking” on the Internet, you’ll find the most popular advocates of this concept are R. Nelson Nash (“The Infinite Banking Concept”), Pamela Yellen (“Bank On Yourself”), Jeffery Reeves (“YouBeTheBank”), Don Blanton (“Circle of Wealth”), and the folks at LEAP (leapsystems.com). Every advocate has, up to this point, been able to explain the concept with varying degrees of success.
The concept, in it’s simplest form, is this: create your own private banking system, of sorts, by saving up some money. Then, use this pool of money to finance everything in your life. If you think about it, it makes perfect sense. Regardless of what you do in life, whether you spend your money or you invest it, you have to use a banking system to facilitate the transaction. All of the money in the world goes through someone’s bank. Advocates of the banking concept argue that you should just set up a “private bank” of your own and use that. That sounds sensible.
Using Dividend-Paying Whole Life Insurance
A basic financial planning strategy is to establish an insurance plan that pays for your future financial obligations, and then to build a secure savings that eliminates the need for the insurance. The key word here is secure. The fact of the matter is that it’s not literally impossible to buy a term life insurance policy and invest the money you’d save by not buying a whole life policy (called “buy term and invest the difference”). It is somewhat impractical for an amateur to do it, and do it with the same amount of efficiency as a life insurance company while creating a solid savings that you can’t lose. There’s nothing wrong with having a secure savings. It’s like a foundation for a home. You build the foundation. Then you build the house. If the house falls down, well at least you have something from which to rebuild. Enter whole life insurance.
Whole life insurance allows you to integrate your insurance and savings by building up a savings (the cash value) that replaces the insurance (the death benefit) over time and do it on a guaranteed basis. Some life insurance companies take this one step further and offer potential for you to earn dividends (which are not guaranteed to be paid) on the policy which can grow the death benefit and cash value over time. Once earned, you can never lose the dividend payment or corresponding cash value.
When actuaries describe life insurance, they describe it in terms of an indivisible contract. There is no actual separation of cash value and death benefit. So a $100,000 insurance policy, with $50,000 of cash value, means that you’re only paying for $50,000 of insurance (not $100,000). The difference between the cash value and pure insurance coverage is called the “net amount at risk.” This decreasing net amount at risk function is how insurers can afford to insure your life to age 100.
The whole reason this banking concept works is because of the nature of the cash value buildup. Think of insurance contracts as existing on a continuum. On the far right hand side of the field, we have term life insurance. You pay low premiums and you have no cash value. Moving on over to the other side of the field is a single-premium policy. You pay one outrageous premium payment, and have that amount available immediately as cash value in the policy. You’ll notice that, as you move beyond the term life product, these policies become a combined savings and insurance contract. Somewhere along the way to riches, fame, and power, we run into the MEC guideline:
A modified endowment contract (called a “MEC”) is IRS-speak for a life insurance policy that has failed the Guideline Premium Test (GPT) or the Cash Value Accumulation Test (CVAT) outlined in the tax code at IRC section 7702. If you fund your policy so heavily with premiums that it crosses that MEC line, then the IRS will reclassify your life insurance contract as an investment, and all withdrawals and policy loans will be subject to income tax.
Your access to cash values will also be restricted prior to age 59 1/2 (basically, your policy will be treated as a non-qualified retirement account). In other words, it destroys the flexibility and advantages of the policy. Bad idea. Don’t do it if you want to use your policy for banking purposes.
In order to do this banking concept thing, you are going to need access to all of those cash values. You do this through the built-in policy loan feature of your contract. Policy loans are very different from traditional bank loans. First, there is no credit application and your loan is only limited by the amount of cash value you have available in the policy. Secondly, there is no set repayment period. You may choose the terms of the repayment. You may even keep the loan open until your death. If you do, the insurance company will simply deduct the loan amount from your death benefit and pay your beneficiaries the remainder. When you want to take out a policy loan, you simply call up the insurer and request a policy loan. The insurance company issues the loan, and then secures the loan amount with an equal amount of cash value from your policy.
For example, if you have $100,000 in cash value in your policy, and you want a $10,000 loan, the insurer will give you $10,000 and then secure the loan with $10,000 from your cash value. This leaves $90,000 available for future loans. As you repay the loan, your cash value is restored with each payment. What’s really special about these loans is that the insurer will continue to pay interest and dividends on the original $100,000 amount if you set up the loan provisions properly when you first set up the policy contract. This results in the cash value growing as though no loan was ever taken. Your savings becomes incredibly efficient because you can spend the money on whatever you want while it continues to grow for you. Pretty cool, huh?
How Nash, Yellen, and Others Do It
There are many advocates of the banking concept out there. R. Neslon Nash was the first. Others followed, like Pamela Yellen (“Bank on Yourself”), Don Blanton (“Circle of Wealth”), Jeffery Reeves (“You Be The Bank”), Douglas Andrews (that “Missed Fortune” guy) and the folks over there at L.E.A.P..
Most advocates of the banking concept tell you to use a “life paid up at 65” policy. In order to build up the cash value quickly, you have to do something called “overfunding” the policy. This is done by adding a special rider to the policy, called a “paid-up additions” rider.
The rider modifies the contract to allow additional premium payments to be made. The additional premium payments go directly towards buying paid-up life insurance death benefit which has its own cash value. There are no (or very small) commission payments paid to the agent on this additional insurance so the cash value for the additional paid-up insurance grows rather quickly. It basically tries to turn the “paid up at age 65” policy into a 10-pay policy in terms of cash value growth.
The problem with this method isn’t that it can’t be done. It’s that it’s wickedly complicated and difficult for the average person to follow. Overfunding a policy requires an understanding of what a modified endowment contract is, how to take policy loans and repay them with a paid-up additions rider on the policy, and monitoring how much money you’re paying towards the additional paid-up insurance rider when there is no loan outstanding so that the insurer doesn’t cancel the rider (most insurers will cancel the paid-up additions rider if you don’t use it after a certain period of time, though I’ve never heard an insurance agent adequately explain this to a client).
You also have to schedule the dividends to pay for the policy premiums after a certain number of years and keep an eye on dividends. The dividends will, after a certain number of years, have to try to do two things at once: pay for policy premiums and buy additional paid up insurance. This necessarily puts a drag on cash value growth. On top of that, if the dividends are ever insufficient to pay the policy premiums, then you’ll have to start making premiums out of pocket again. If you have a loan outstanding on your policy that you’re repaying, and you suddenly have to start making premium payments again, that puts a kink in your “banking system.”