Life insurance premium financing involves taking out a third-party loan to pay for a policy’s premiums. As with other loans, the lender charges interest, and the borrower (the insured, in this case) repays the loan in regular installments until the debt is satisfied or the insured passes away, in which case the balance is typically paid off with insurance proceeds.
This strategy may be useful to high net worth individuals (HNWIs) who don’t want to liquidate assets to pay for costly life insurance premiums outright. But is the practice too risky?
- Life insurance premium financing uses borrowed money to fund insurance policy premiums.
- Those with very large life insurance policies may find this option attractive in lieu of liquidating assets to find the cash.
- The higher the amount of your life insurance policy, the more costly the premiums on it.
- Three areas of risk for insurance premium financing are qualification risk, interest rate risk, and policy earnings risk.
- One concern would be that the cash value of the policy may not increase as fast as the interest rate.
Why Go for Insurance Premium Financing?
First, let’s look at why people would even consider insurance premium financing. Nearly 52% of Americans have a life insurance policy to make sure their loved ones would be financially secure if the insured passed away.
Premiums vary greatly depending on policy type, your age, your health (and health habits), and, of course, the size of the policy.
A 47-year-old nonsmoking man, for example, could get a 20-year $100,000 term life policy for about $19 per month; the premium would go up to about $34 per month for a $250,000 policy.
HNWIs, however, are typically looking for coverage in the millions or tens of millions of dollars to address business, inheritance, and tax issues. A $25 million 20-year term life policy for the same person might run about $2,100 a month, and—here’s where it can get really expensive—a whole life policy would start closer to $15,000 a month.
Because premiums can easily cost upward of $100,000 or more a year, premium financing can make sense since it allows people to borrow at a rate close to a benchmark short-term rate while keeping the money they would have spent in investments that yield a higher ROI. Premium financing can also prevent the insured from triggering capital gains taxes had they liquidated assets to let them pay for the premium upfront.
Taking out a personal loan to pay for high insurance premiums may come with fewer risks than using insurance premium financing.
Although the strategy is appropriate for some individuals, it does pose certain risks that should be considered before making any decisions. These risks include (but are not limited to):
Interest Rate Risk
Interest rates are low now, but if they rise it could spell trouble. “Most of the time a premium finance loan will have a variable interest rate,” says James Holtzman, a certified financial planner at Legend Financial Advisors. “Right now that’s a great thing. But when [interest rates] rise, it could really eat into the advantages you were trying to accomplish in the first place.”
Lenders typically require borrowers to re-qualify each time the loan is renewed, at which time the loan’s collateral is re-evaluated (collateral might include real estate, stocks, and other assets and investments). If the value of the collateral has fallen below a certain threshold, the insured may have to provide additional collateral against the loan.
Otherwise, the loan could become due or be offered for renewal at a higher rate. Since the loan is renewed at the end of each term until the insured passes away, qualification risk is always present, whether it’s related to collateral value or some other factor under the lender’s underwriting standards.
Policy Earnings Risk
If the policy’s cash surrender value underperforms, the loan balance could exceed the value of the collateral, in which case the insured would be forced to provide more collateral to avoid default.
Likewise, if the death benefit fails to grow, the policy could provide less coverage than expected when the loan is finally satisfied. In the worst cases, the insured’s estate would have to repay the loan if the death benefit could not.
What is premium financing life insurance?
Premium financing uses borrowed money to pay for life insurance premiums. This is most often done in conjunction with very large policies (that pay very large death benefits), so that the policy owner does not need to tie up their own capital. Instead, the capital is used as collateral for the loan.
How do you qualify for premium financing?
Lenders involved in premium financing will want to ensure that the following criteria are met:
- The insured is financially savvy with a high net worth (but with limited liquid assets)
- The insured is under age 70 and in good health.
- A clearly demonstrated insurable interest and financial need.
- Existence of additional collateral being pledged besides the insurance contract alone.
- Involvement by outside legal or financial counsel.
- A demonstrated exit strategy besides death benefit payoff.
How do premium finance companies make money?
Like other types of loans, those engaged in premium financing earn money from the interest payments made on the borrowed money.
The Bottom Line
A qualified financial planner or advisor can help you mitigate some of these risks. Interest rate risk, for example, can be reduced (or eliminated) if the lender puts a cap on how high the interest rate can rise, or if it offers a fixed interest rate. And to reduce policy earnings risk, the insured could add a special death benefit rider.
Measures such as these typically add to the cost of the policy, but they do help lower the risks associated with insurance premium financing and can provide peace of mind. In the recent past, financial experts might recommend taking out a home-equity loan to support high premiums on health insurance. However, under the 2017 Tax Cuts and Jobs Act, it is no longer possible to deduct the interest of a home-equity loan if the money is used for something other than purchasing, building, or renovating a home. Today, to avoid these risks completely, you might consider a personal bank loan.