A simple definition for Arbitrage would be the process of buying something for one price while simultaneously selling it for another price. In case you missed that, the word “simultaneously” is important. It means that the buying and selling happen at the same time.
In other words, if you buy something for $10 and later sell it for $12, that is not arbitrage, it is just a wise market decision. If however, you have a seller of a rare comic book on the phone, and also have a buyer on the phone, and you can make a profit by buying and selling at the same time – that is arbitrage.
Arbitrage happens all the time with online trading because the global markets are inefficient. If you’ve ever sat in traffic during rush hour you know very well that life on our precious planet is anything but efficient. If a company has a big breakthrough, it may take time for the information to get to all the markets.
In the world of the Internet, the time for information to travel is relatively quick, but that doesn’t mean that online traders can’t take advantage of short windows of opportunity. In fact, most big institutional trading firms have programs and algorithms looking for these little differences in order to automatically take advantage of the gains that can be made through arbitrage.
Okay, so that’s a little vocabulary work out of the way. Now let’s talk about the Infinite Banking Concept® (IBC) and ultimately how IBC can take advantage of arbitrage to grow your money.
What is Infinite Banking?
The term “infinite banking” was originated by Nelson Nash who wrote “Becoming Your Own Banker” and is generally deemed the originator of this strategy, at least as far as it is a recognized financial strategy. Another recognized promoter of this strategy is Pamela Yellen and her best selling book “Bank on Yourself.” Other more general terms such as becoming your own banker, personal banking strategy, self banking system, or any derivation thereof refers to this strategy.
All of the above are referring to a strategic process that uses whole life insurance in a way that is different from what is commonly promoted in the mainstream life insurance community. If you’ve never heard these terms before, they may seem fanciful or confusing, but really it’s just a creative way to state that you are capturing the interest that would normally be paid to a bank, by paying the interest toward a policy you own.
Paying the Bank
Some will say that you are “paying yourself” or that in the case of Yellen, you are “banking on yourself.” But ultimately it just means that you pay interest to your mutual life insurance company instead of to a bank. You are part owner of the insurance company, so you reap benefits associated with paying the company. But it’s actually so much more, as explained below.
Before going too much further, let me give you an illustration that may help you understand why people want to use Infinite Banking to create your own personal banking system.
Buying a Car through a Bank
If you are like most Americans, you’ve purchased a car by financing provided by a bank. Whenever you see car makers talking about 3.9% financing or something similar, you know they are trying to get you into their dealership by touting their low interest rates on car loans. Let’s look at the details of buying a car through a bank a bit further.
If you walk into a dealership today and ask to purchase a $30,000 car with zero down payment, you’ll still get plenty of takers. Assuming of course your credit rating is high enough. If you do get approved, and the terms are 60 months (5 years) and 3.9% interest rate, your payment will be $606.26 (assuming a 10% sales tax). The total cost is $36,375.43, with $3,375.43 being paid in interest.
You get the privilege of taking the car home without paying anything up front, and in return the bank will get $3,375.43 in interest over the course of five years. At first glance it seems like the bank is doing pretty good. Most people would agree that the bank made a good amount of money for doing very little. In reality, the bank took on a bit of risk (you could have driven the car to Mexico and never made a payment), they pay employees to handle the loan processing and the monthly payments. And of course if you ever have any questions or concerns they need to have people that answer the phones and respond to your requests.
What about Inflation?
In addition, the money that you paid back to the bank had been subject to inflation, so it was worth less and less with each passing year. So the bank didn’t really make $3,375.43, they actually made $3,375.43 minus the five year impact of inflation, which varies. But that’s a side note. If you’re interested you can read our article about financial leverage and the time value of money.
But the main point is that you would be paying $3,375.43 to the bank in interest. What happens when you buy the car with Infinite Banking?
Infinite Banking Example: Buying a Car
Now with this infinite banking example let’s assume you want the same $30,000 car, at the same dealership, but you have a cash value life insurance policy through a mutual company. What do you do? How does it work?
First of all, you still need to acquire the money.
But the money acquisition is fairly simple. You call your insurance company, ask for the money, and they send you a check. The only qualification is that you have the amount of money in cash value within the policy. Assuming you have the cash value available, you get a check in the mail and you deposit it in your bank account.
Ideally you work with your agent to work out a payback schedule based on the interest rate for the loan. The payment amount would be exactly the same if you chose to follow the same payback schedule and the same interest rate. So, what’s the difference?
Is Payback Required?
With the infinite banking example using cash value life insurance, if you don’t want to pay back the loan, you can choose not to pay it back. And nobody will come repossess your car! But you will pay interest on it each year and it will impact the growth of your cash value in your whole life policy.
Ultimately, if you choose not to payback the loan, it will be paid back in full when your death benefit is paid out. The insurance company will deduct the outstanding loan balance from the death benefit prior to issuing the life insurance benefit to your beneficiaries.
So the fact that you don’t have to worry about your car being repossessed is a nice thing. But there is much more than that.
How do life insurance loans work?
When you take out a life insurance loan you are borrowing money from the insurance company’s general account, using your cash value as collateral.
So you are not actually borrowing your own money, but the insurance company’s money. The cash value in your policy remains in your policy. The insurance company loans you money that was earmarked for policy owner loans, investing in bonds, investing in real estate, or investing in other investment grade securities.
Note: It is possible to WITHDRAW money from your policy cash value, but it is not recommended. When you WITHDRAW your cash value you are removing it from the policy and therefore it will impact the cash value growth – policy loans are a better way to access the money in most situations. Although there are situations in which WITHDRAWALS are recommended, but that’s a topic for another time.
Now here is a huge benefit; with a properly structured policy from a mutual insurance company that practices non-direct recognition. The cash in your policy continues to earn interest that is guaranteed plus any potential dividends, even though you took out a loan against your life insurance cash value. That means your cash value is continuing to grow via compound interest, even though you are using it as collateral to purchase this car!
Policy loans are similar to home equity loans
If it helps, you can compare policy loans to a home equity line of credit (HELOC) on your house. Your house may be worth $400,000, and you may owe $300,000 on the house. If you get a HELOC for $50,000, you will have less equity in the home, but the home will still appreciate at the same rate regardless of the amount of equity you have.
In a similar fashion, if you have $50,000 of cash value in your policy, and you choose to get a $25,000 policy loan, the dividends paid to the policy will still grow on the total amount of $50,000. But just like a HELOC, there are some interest charges to consider.
Arbitrage and your policy loans
So what numbers do we need to consider here? We need to consider the policy loan interest rate, and we need to consider the guaranteed interest rate plus the average dividend. Some companies offer a wash loan which is just another way of saying they will credit you the same amount that they charge you. Essentially you get a 0% loan. But if you look at the national averages you’ll find that most companies will charge between .5 and 1% after the guaranteed rates and interest charges are considered.
In other words, an insurance company may offer a guaranteed rate of 4%, but will charge 4.5% on all policy loans. But remember, there is a dividend for policies holders of mutual companies! If the dividend is 1.5-2.5%, then you have positive arbitrage of 1-3%.
A Long History of Dividends
Just as a point of reference, Mass Mutual has a report that shows their dividend rates going all the way back to 1978. In that time, the lowest the dividend rate has been is 6.80%. That rate is the guaranteed rate plus the dividend, so you get a total of 6.80%. If you are paying a loan rate of 4.5% or even 5%, you are still earning positive arbitrage of nearly 2% in the worst year.
If you have been following the bouncing ball thus far, you can see that you are borrowing money and yet being paid to do so. It is true that the dividend is not guaranteed, so it’s not something you can be 100% certain will take place. But the track record of dividends is quite impressive with most mutual insurance companies. So although it is not guaranteed, it is indeed a rather safe endeavor.
Why do they call it “Infinite” banking?
This arbitrage that is in your favor when you take out a policy loan is a tremendous opportunity. When people start using their policies like this, they see the benefit and they want to do it more and more, over and over, to grow their cash value (infinitely).
Think about it for a minute. When you borrow against your policy (use your cash value as collateral), you are still receiving dividends on your full cash value, AND you get the use of the cash on loan to invest in something else.
Let’s say for example you want to buy some real estate. You use the policy loan money to put a down payment on a rental property. The property is cash flow positive and you are making positive arbitrage on your policy loan. If your rental property goes up in value during the year by 5%, you can add an additional 2% on top of that because of the positive arbitrage.
And to make it even better, you can choose to pay the loan back at a higher interest rate in order to increase your cash value. All the while you are taking advantage of the principle of compound interest, without disturbing the cash value principle in your policy! Another thing to consider is how all of the above keeps your money in motion working for you. This concept is called the velocity of money.
I’ve only scratched the surface with the ways in which you can use these policies. If you’re interested in the Infinite Banking Concept® and are curious how to get started, give us a call. This type of “banking” is not for every individual, but for those that have the discipline and the means, it can be a door that opens up a whole world of financial possibilities.