Capital is usually the single greatest barrier to any entrepreneur starting a business.
Even service-based companies still require a significant amount of capital to cover major expenses such as rent and labor. A solution that’s available to help overcome this barrier is using your insurance as the seed funding.
You’re allowed to take loans against your life insurance policy. This may be done in a variety of methods, but the easiest is taking a loan directly through your insurance policy holder against the value of your life policy. Three types of life insurance policies you may use to take a loan are (1) whole life insurance, (2) universal life policy or a (3) variable life policy.
The benefit of a life insurance loan for an entrepreneur are (1) no credit or background checks that will affect your credit history, (2) flexible payment schedules because you’re not required to make monthly repayments and (3) lower interest rates.
Life insurance loans don’t require credit checks because the loan is financed by your life insurance policy. It’s similar to taking a loan from your own 401(k) or your own money that was put aside, thus the lender already has collateral that they can hold against the loan. This makes the time between you obtaining the “loan or cash” and application much faster than a traditional bank loan.
For example, a traditional home equity loan application requires at least three months to obtain approval. Most banks will preliminarily approve you for a home equity line, but this “approval” is misleading. The bank’s approval is only an agreement to consider your home equity line application. It will require additional information such as proof of income, an appraisal of the property and other information before the bank is able to reach a decision. It will take weeks to months to gather the information, communicate with the bank’s underwriters and have the bank reach a final decision.
No Monthly Payments
The loan is secured by your life insurance policy, so you’re not required to make monthly payments like a “mortgage.” This is the most important benefit of a life insurance loan. It’s a tall order to ask an entrepreneur to guarantee a stable and regular expense. There will be months where you’ll be doing great financially and months where you’ll wonder how to keep the doors open. Having the option to decide, whether to make a payment against the loan will literally determine whether you’re able to stay in business.
The main factor that determines whether you’re able to continue to avoid making payments is the interest rate and the cash value of your insurance policy. If your loan exceeds the cash value of your insurance policy, then you will “surrender” or “lapse” your life insurance policy. Basically, you’ll lose your insurance policy.
Surrendering or lapse your insurance policy will like cause a “taxable event.” For example, if you have a life insurance policy that has a cash value of $100 dollars and you paid $50 dollars in premiums for the policy. When your loan against the life insurance policy is equal to $100 dollars, then you will surrender or lapse your policy. Surrendering or lapsing this policy will cause you to recognize $50 dollars in taxable income. This income will be treated as ordinary income that is taxed at your marginal tax rate. Thus, it’s important to never surrender or lapse your life insurance policy because it will cause you to recognize phantom taxable income.
The best way to avoid this problem is to simply make payments on the interest only to prevent the loan from growing exponentially. You may decide how or when to make these interest payments to make sure you avoid surrendering or lapse your life insurance policy.
Lower Interest Rates
Interest is important for every entrepreneur to understand. Usury law or the law the governs what a lender may charge for interest is controlled by each individual state’s law. Typically, most states require interest rates below 20% with exceptions based on the amount of money borrowed. Credit cards usually charge initially between 12% to 19% interest. Home equity loans charge between 3% to 7% interest rates. A private loan from a non-institutional source such as mid-market loans, private equity and etc will typically charge at least 14% to 19% interest.
A life insurance loan will typically charge between 5% to 9% interest. It won’t be as low as traditional bank loans collateralized by real estate, but it’s significantly better than our other alternatives. The interest rates for life insurance loans are favorable because they’re lower and traditional banks are not lending to entrepreneurs. Keep in mind that small business loans guaranteed by the SBA charge between 6% to 8.25% interest. Thus, the interest rate applied under a life insurance loan is reasonably manageable.
Cons to Loan Insurance Loans
Nothing in life or business is perfect and this is no exception. The drawback of a life insurance loan is that you’ll need a “life insurance policy.” Usually it takes years to build enough “cash value” to effectively take a loan against the policy. Richard Reich, president of Intramark Insurance Services, Inc., explains that it “typically takes 10 years to have sufficient cash value.”
Thus, starting an insurance policy early helps prepare you for an unfortunate accident as well as the opportunity to save for a business. An option for your children is to start a life insurance policy early, so that they’ll have the opportunity to be covered under the policy and the option to use the policy as an “investment fund” for their future company.
Taking a loan against an insurance policy is not taxable. It is a common practice for wealthy or high networth individuals to obtain life insurance policies and to draw against them through loans. Money received through life insurance policies are not taxable, but the problem is that you’re dead before you’re able to enjoy the money. Taking a loan against the value of the life insurance policy allows the policy holder to enjoy the fruits of the policy before their death.
Even companies are able to obtain life insurance policies for their executives through “keyman or key person” life insurance policies. The money a company receives through these life insurance policies are not-taxable to the company under the exceptions enacted by the Pension Protection Act of 2006.
Ironically, death is the ultimate tax avoidance strategy. The trick is to use death to avoid taxes before death actually finds you!
This thought piece is courtesy of Cameron Keng and Forbes.com / Feb 16, 2016