Should Savvy Business Owners Own Whole Life Insurance?
Cash-value life insurance–e.g. whole life and indexed universal life insurance–offers the policy owner the option to use policy values while he/she is still alive. There are a few ways to go about this, but today I want to talk about the loan feature.
Taking a loan against a life insurance policy is one of the most basic features these contracts afford their owners. But the implications of what’s possible when a loan is available are quite astounding.
This is uniquely important to many small business owners.
Cash”Flow” is King
I’m a small business owner. And I don’t necessarily mean that in the context of owning an insurance practice. Yes, a service business is technically a form of small business ownership, but non-service businesses have several needs that are often nuanced vs. a service business. I happen to own a non-service business–in addition to this one that sells insurance which is no doubt a service business.
When I started the business several years ago, I smugly thought that my success in the insurance industry made me a shoo-in for success elsewhere. That was dumb. Like really dumb.
Something I completely underestimated early on was the power of cash flow when running a small business. You can have an incredible margin. It means nothing if you cannot turn a product over quickly or for a meaningful amount of absolute dollars in your pocket.
Truth be told, this is a real struggle for a lot of businesses.
It’s why they rely so heavily on banks.
And banks love small business owners for this very reason.
Lending provides necessarily capital in-lieu of cash flow, but it comes with the anticipation of cash flow at a later date…fingers crossed.
Successful businesses ultimately create this cash flow; unsuccessful ones do not.
But even successful businesses sometimes struggle with the timing of their receivables vs. their payables. Again, the banking industry stands ready to offer a helping hand and profit greatly off this timing in-flows and out-flows disequilibrium.
Whole Life Insurance Helps Small Businesses Boost Profits
Borrowing money costs money. I don’t think I’m pioneering any sort of new territory with that statement. But what I do want to present is the notion that too many people default to believing that their only option is to ask the bank for money, pay them their ask, and carry on as planned.
I’ve meant a lot of successful business owners throughout my professional life. I’ve meant people who I never imagined would generate sales figures with the products they chose to bring to market.
But just as surprising as what thing-a-ma-bob was a sleeper million-dollar idea, is the fact that all of them rely on credit to meet basic daily operational expenses.
I’m not bringing that up to be dismissively judge-y. I completely understand the logic employed. Credit ads to working capital, which puts a multiplier on business results. If you’ve also identified that your business appears to scale in the sense that spending money on x produces y results which is some number larger than x, then more working capital to pump in more x to attain more y is a fundamentally good idea.
The problem is capital can be a tad expensive when you start to try and acquire it through banks. Interest rates are near historic lows–probably not for long, more on that in a minute–and yet most small businesses with multi-million dollar revenues often create working capital with loans that use annual interest rates north of 6%–often double that. And borrowing money comes with a multitude of consequences that may alter future business decisions.
Now I don’t mean to dismiss the use of traditional lending to have the capital needed to conduct business. Assuming the business has the cash flow to afford the cost of financing whatever activity for which it has a capital need, it makes perfect sense to borrow the money. In fact, not borrowing the money despite the net gain the business achieves through generated revenue would be foolish.
However, using life insurance to finance the activity could be a way to wring out an additional profit.
Let’s say you need $1 million to finance inventory purchases for the coming busy season. You can borrow at 6% interest and you intend to repay the entire loan in six months.
Most lines of credit used by businesses in this fashion are revolving loans. They have no specifically defined payment period, but interest will be charged and due by the borrower once every month. The business owner can choose to make payments to the principal, but at the very least must make an interest payment each month. In this case, the monthly interest payment if no payment is made to principle should be around $4,932.
If the available line of credit is larger than $1 million it’s possible that the business owner might have the option to draw additionally against the line of credit to cover the interest due for a few months while the business awaits cash flow from the anticipated business season.
Taking the loan does place–at the very least–a $1 million liability on the company’s balance sheet.
If things work out as planned, then the business will sell the majority of the inventory it buys with the loan and would theoretically raise somewhere around $2 million from the increased sales.
If the business made monthly interest payments to service the debt, it could pay off the loan after selling inventory. Assuming the original six-month timeline, it would net $970,408.
If on the other hand, the business chose to draw additionally against its credit line to repay via one payment at the end of six months, it now has a loan balance of $1,418,519. The good news is, we decided the business made $2 million off this activity so it has plenty of money to retire the loan balance. The bad news under this scenario is it will only net $581,481. The good news is, the interest paid by the business is tax-deductible.
If the business financed this same inventory purchase with a life insurance loan, and we assume the same 6% annual interest rate, there is a lot of overlap in terms of how the loans work. The life insurance loan will also function like revolving debt, except that it will not have a monthly payment due. $4,932 should be the accumulated interest on the loan after the first 30 days but there is one significant difference.
The life insurance loan will not compound monthly. The business will also have zero obligation to make an interest payment each month. So the business can skip payments entirely for six months and then make one payment after selling the inventory and the cost of the loan is the same as the prior scenario where the business made monthly interest payments to the loan.
If the business chose to make payments in the amount of the interest due on the traditional bank loan, none of those payments would have gone to interest. Instead, they reduce principal further decreasing the interest accumulation–and therefore cost–of the loan.
So to ensure clarity, the business can borrow the $1 million from a life insurance loan, commit zero cash flow to service the debt until repaying it in one lump sum six months later and net the amount it achieved with the traditional loan where it had to commit cash flow to service the debt to keep the loan balance from growing every month. And the loan interest paid on the life insurance loan is also tax-deductible.
Things Change Life Insurance Generally Doesn’t
Lastly, I want to highlight that lines of credit can vary considerably as economic conditions change. As interest rates bounce around, banks can choose to move interest due on lines of credit. This change can be frequent and it can dramatically alter the cost of borrowing through a business line of credit.
Available credit can also change. If a bank deems a change in creditworthiness, it might choose to reduce a line of credit on a business. This can limit options at very inopportune times.
Loan provisions on life insurance policies have very limited options for change. Even policies with variable interest rates generally have contractual guarantees to only change once per year. Credit lines are tied to available cash surrender value so there is nothing the insurance company can do to take credit availability away. There is no credit check for a life insurance loan and no application process to get one.
Additionally, life insurance loans are not reported to the same credit system banks use. They do not impact metrics banks use to evaluate how leveraged someone is. If you have a $1 million outstanding life insurance loan, and you need to borrow from a bank, the $1 million life insurance loan doesn’t count as a consideration for your creditworthiness.
And when you take a loan against a life insurance policy, you still earn guaranteed interest and (depending on the contract) some non-guaranteed interest or dividends on the cash value in your policy. In other words, you have the ability to use the cash value to grow your business, while still earning money on the money in your policy.