What is Premium financing for Life insurance?
Premium financing involves borrowing money from the bank to purchase a life insurance product such as Universal Life plans (IUL), Single premium whole life annuity plans. As such, this allows the policyholder to fork out a lower initial capital by leveraging against the life insurance plan. This may seem enticing to the policyholder as it frees up cash, and may seek an investment rate of return that is higher than the financing rate.
An illustration of how Premium Financing for life insurance works
A 45 year old male applies for Single Premium Whole Life insurance plan for Death benefit of $3,200,000 for Legacy planning. The single premium, if he chooses to pay fully is $839,000. The plan has a first day guaranteed cash value of $675,395.
With premium financing, he is able to borrow up to 90% of the plan’s first day cash value, which equates to $607,855.50 ($530,000 x 90%), to pay for the Single premium plan. As such, his initial capital to be paid for the plan has substantially reduced to $231,144.50, and will continue to pay a monthly payment base on the borrowing interest rate.
What are the various risks to Premium Financing for life insurance?
1. Borrower’s liquidity risk: If the policyholder is unable to service the monthly payment, the policy will risk being surrendered and lose the insurance coverage. In addition, the policyholder will also have to re-pay the full loan amount back to the bank. If the surrender value of the policy is less than the outstanding loan, the policyholder will be left with significant debt.
2. Bank renewal risk: It is up to the Bank’s discretion if they will allow the policyholder to continue to finance the policy. Should the bank decide to stop financing, the policyholder has to repay the financed amount.
3. Interest Rate risk: The cost of financing is variable, and will be subjected changes. In the past, when interest rate was low, policyholders were enjoying a lower cost of financing. However since 2022, the cost of financing has been increasing due to higher interest rate environment. This has resulted in many existing policyholders to experience a negative rate of return. When we were enjoying low borrowing interest rates prior to 2022, premium financing was an attractive proposition. However, we have now seen a spike in borrowing rates due to rising inflation, and may continue to have borrowing rates at this elevated level.
What are the options if you are currently on premium financing for your Whole Life insurance and is generating a negative yield
1. Continue paying for the policy: Interest rate is out of our control, and we are not able to predict when or if interest rate will trend down. Should interest rate remain elevated in the long term, this option may prolong your losses due to the loan interest payment.
2. Cut your losses, take charge and invest on your own: In the short term, while it may be painful to terminate the policy and potentially realize a loss in surrender value, switching to other strategies such as ‘’Buy Term, invest the rest’’ may prove to be wise in the long term. When it comes to whole life insurance, the returns on the cash value of the policy is out of your control and is dependent on how much bonus the insurers declares to you, or the crediting rate of the Indexed Universal Life. By investing on your own, you may potentially ‘outperform’ the returns of your existing Whole life insurance.
Assuming the policyholder is in the 5th year of his Whole life insurance with Premium financing at current borrowing rate of 5.5%p.a
By surrendering his plan, he will receive a projected cash value of $706,714. He has to repay the bank the loan amount of $607,855, and receive a net surrender value of $98,859.
He purchases a new term plan (Base on age 50 now), for the same sum assured of $3,200,000 to cover till age 85. The premium is $955.70.
With the new term plan, the policyholder will significantly reduce his monthly cash outflow from $2,786/mth of loan repayment to policy premium of $955.70/mth instead. With the reduction in cash outflow, he is able to invest the difference to potentially obtain a higher investment return in the long term.
Consult with us
To conclude, we have reviewed the merits, and potential risk of premium financing of life insurance. To help review your options carefully, speak to our partnered financial consultants.
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