The infinite banking concept is a strategy that was originated years ago by Nelson Nash as described in his most book, Becoming Your Own Banker.
We’ve embraced his philosophy here at insuranceandestates.com as discussed in our top dividend paying whole life insurance article, not because it is a perfect solution for everyone, but because it characterizes most of our core values and helps many people achieve financial wellness.
In a nutshell, Mr. Nash offered an alternative financial philosophy that was based upon personal discipline and strategically using the contractual stability of a dividend paying whole life insurance contract in a unique and powerful way.
The Infinite Banking Concept® [A Brief Review]
The bird’s eye view of Mr. Nash’s coined idea of infinite banking is that you expedite the growth of cash value accumulation in your whole life policy by using what is called a paid-up additions rider.
Cash value accumulation is accomplished by the payment of life insurance dividends which can be added back to the cash value in your policy.
The receipt of dividends is coupled by the tax advantages of life insurance for cash value growth.
All of this efficiency provides a way to ultimately become your own banker with life insurance if you follow the system as set forth.
To unpack this concept further, building up a reserve of ready cash in your life insurance policy provides a way to obtain financial leverage through your life insurance policy to pursue other perhaps higher risk endeavors such as real estate investing with infinite banking, investing in crypto currencies (perhaps), investing in the stock market OR whatever your area of expertise is.
The idea behind this concept of financial leverage and potential arbitrage is that you can take loans from your life insurance policy much more easily and cost effectively than you could from a traditional bank.
I often equate this to borrowing against the equity in a piece of real estate, except that it is much quicker to get a policy loan AND you continue to receive dividends. We’ll get back to this idea in a second.
The point is that when using a properly designed whole life insurance policy to build up cash value AND using policy loans effectively to fund other ventures, or even your home or vehicle purchases, you can achieve financial independence.
You can also maximize the velocity of your money by keeping it performing in multiple ways, both inside of your policy AND applied to other outside investments.
Back to the dividends which are really the focus of this article.
Whole Life Insurance Dividend Crediting Rates
One of the keys to obtaining financial leverage to pursuing other investments is to create financial arbitrage with your money. If you can borrow a policy loan at say 5% and your dividend rate is 6.5%, you would have a 1.5% arbitrage on your money and this would allow your policy to keep making money (1.5%) regardless of your policy loans.
For this reason, Nelson Nash recommended that folks use a life insurance company that is NON-DIRECT RECOGNITION vs. DIRECT RECOGNITION to make sure your policy performance is not affected by taking policy loans.
Unfortunately, the direct vs non direct recognition conversation is not simple and thus is the subject of much hand wringing in the infinite banking community.
Today’s task is to provide a better answer than has been currently offered to one of the key questions posed by those seeking the best infinite banking solution.
Direct Recognition vs. Non-Direct Recognition
As discussed above, whole life insurance, as well as other types of permanent life insurance with cash value, allows access to the cash value in your policy through policy loans. Policy loans charge a loan rate that may be fixed or adjustable each year depending upon the policy. When a policy loan is taken in a participating whole life insurance policy, the loan amount continues to earn policy dividends.
Crediting Adjustments on Life Insurance Policy Loans
Economics requires that policy loans, along with other factors in the economic environment, can have a negative impact on the dividend rates offered by a life insurance company.
This impact, when applied to an insurance policy is called a “crediting adjustment” and there are two ways this adjustment is applied.
These two ways are either Direct Recognition, which passes the adjustment only to the policy holders who have outstanding loans and Non-Direct Recognition, which passes the adjustment to ALL of the policy holders, regardless of outstanding loans.
This crediting adjustment for direct recognition companies can result in a decrease in the dividend rate for those who hold policy loans.
Non-direct recognition insurance companies will not show an adjustment to the dividend rates; however, the dividend rates in total may be lower and it is important to consider this factor.
Direct recognition companies like Penn Mutual contend that their approach is more fair, whereas non-direct recognition companies like Lafayette Life contend that their approach is more suitable for an infinite banking strategy.
However, as we shall see, it isn’t quite this cut and dry.
Margin Loan Rates vs. Dividend Rates
Another important factor to consider is the margin loan rates vs. dividend rates. A margin loan rate can be defined as the difference in the crediting rate between loaned and non-loaned policy values.
For example, the non-loaned dividend interest credit rate may be 6.5% and the loaned rate may be 4.35% resulting in a net loss. Penn Mutual, as an example, responds to this issue by locking in the margin rate to -.65 % in years 1-10 of the policy AND year 11+ at 0% thus allowing for a break even crediting rate on loaned amounts.
The above math is of course based upon the guaranteed vs. non-guaranteed dividend crediting rates and therefore the return on a direct recognition company could in fact be much more favorable than break even.
The Impact of Lower vs. Higher Long Term Interest Rates
With all of the above in mind, something that people often forget is the impact of the interest rate environment on your infinite banking strategy and choice of company for infinite banking.
Non-direct recognition companies tend to be more favorable, and illustrate better, in a lower interest rate environment with a higher margin between the loan rates AND dividend crediting rates. The idea behind this fact is that interest rates will tend to rise much more quickly than dividend crediting rates.
Direct recognition companies, which allow the margin rate to be locked, tend to be favorable and illustrate better in a higher interest rate environment due to the fact that rising loan rates could exceed dividend crediting rates fairly quickly.
The Impact of Costs
Perhaps the most allusive factor when analyzing the policy performance, when considering direct vs. non-direct recognition, is the cost factor.
For example, a company may post a higher dividend rate and yet the illustrated guaranteed cash value accumulation may appear less favorable than another company. Although this is hard to put a finger on, the natural answer is that the company has the internal discretion to allocate its costs. For this reason, insurance companies with huge advertising budgets may carry higher internal costs than those with a more conservative approach.
For all of the above reasons, the decision whether to go with a direct vs. non-direct recognition company for your infinite banking strategy is not an easy one.
There are factors to consider such as our current interest rate environment, company costs, as well as the overall life insurance company rating of the company you’re considering.