by Steve Goodman
CPA, MBA – President & Chief Executive Officer
Contact Steve today for more info.
Premium financing concerns borrowing money to pay life insurance premiums. While there may be multiple reasons to employ this strategy, it is often used to avoid liquidating other investments to pay premiums.
It is important to remember that premium financed insurance is not the same thing as free insurance. Nor is it designed to allow you to buy insurance you couldn’t otherwise afford or don’t need. Premium financing involves risks. These include possible interest rate changes, policy credit rate and valuation of the policy, refinancing and duration risk, and the need to pledge additional collateral outside of the policy.
If lending rates rise faster than policy crediting rates for an extended period, negative arbitrage may occur. The policy values won’t keep pace with the loan balance. In this scenario, the borrower may have to post additional collateral or pay additional interest to prevent the loan amount from growing.
Following are some common questions and answers about premium financing:
Who borrows the money?
The policy owner, usually an ILIT, borrows the funds from a premium finance lender.
Who loans the money?
The lender is usually a large, highly rated financial institution that has set aside funds to be used for premium financing.
How is the interest rate determined?
The interest rate is usually based on a well-recognized benchmark, such as the 12-month London Interbank Offered Rate (or LIBOR) or the Prime rate plus a spread of 100 to 400 basis points.
How often will the interest rate change?
The rate usually changes once a year, based on changes to the benchmark rate, though you can request a longer or shorter lock-in period.
When is the interest payable?
Usually, interest must be paid in advance of the loan and each year on the loan anniversary. Sometimes, interest can be paid in arrears or accrued and added to the loan balance.
Are there minimum loan amounts?
Yes — these will vary, depending on the premium financing program.
Is loan interest tax-deductible?
No, because premium financing interest is considered to be personal interest, which isn’t deductible.
How are premium financing loans structured?
With some programs, each annual premium is considered a separate loan and a new loan process is initiated each year. With others, a term-loan structure is used, with payments made over a period of one to five years.
Is there a loan origination fee?
Most premium financing programs include an upfront loan origination fee.
What kinds of life insurance policies can be financed with premium financing?
Whole life, universal life and index universal life policies – as well as single life and joint survivor policies — can usually be financed.
Is collateral required for the loan?
Lenders usually require that a life insurance policy is pledged as collateral for a premium financing loan. And if the cash surrender value is less than the loan amount, additional assets may also have to be pledged as collateral. Cash, cash equivalents (like CDs), liquid securities, the policy’s cash surrender value, the cash surrender value of other policies, government bonds, personal guarantees, and letters of credit are usually acceptable forms of collateral.
With a fully collateralized loan, 100 percent of the cumulative loan balance is collateralized by the cash value and other pledged assets.
How is collateral handled and how often is it reviewed?
Some lenders require that collateral be transferred to a separate account, while others will accept an assignment of the collateral and allow the borrower to continue managing it. Collateral is usually reviewed by the lender at least once a year.
Will additional collateral ever have to be pledged?
If the life insurance policy or pledged assets perform poorly, the lender may request additional collateral from the borrower.
How and when must the loan be repaid?
Premium financing loans must be repaid at the end of the loan term, when the insured dies, or if the loan defaults. Cash can be withdrawn from a policy’s surrender value to repay all or a portion of the loan. Or the loan can be repaid using outside funds, such as existing assets, the liquidation of a business interest, or outright gifts.
Are there any additional planning strategies for borrowers when it comes to premium financing loan repayment?
This depends on several different factors, including the borrower’s age. For example, older individuals whose life expectancy is less than 15 years might consider having the loan repaid after they die. But this may not be wise for younger individuals due to the long-term risks of changing interest rates, unpredictable policy performance and issues with collateral.
If a policy is owned inside an ILIT, it may make sense to gift the money into the trust so the trustee can repay the loan, although there will be gift tax implications. Or, the insured may loan money to the ILIT so the trustee can repay the loan, or make annual gifts to pay loan interest. Alternatively, the ILIT can accrue the loan interest, which is added to the loan balance. Both the accrued interest and the loan balance will be included in the insured’s taxable estate.
If a policy is owned outside the insured’s estate, this could eliminate the need to lift the entire premium — only the loan interest may have to be gifted. If the loan interest exceeds available exclusions and exemptions, it may result in a gift tax liability.
Should You Consider Private Financing?
Private financing is similar to premium financing except that a family member, instead of a financial institution, usually serves as the lender. The private financing arrangement is usually between a family member and an ILIT created for the benefit of heirs, or between family members of different generations.
With private financing, the insured pays life insurance policy premiums with funds received from the family. Interest can be paid annually or accrued, and a portion of the policy’s proceeds may be assigned to the lender as collateral. All private financing loan transactions should be made in writing.
Required legal documents to support a private financing loan include the ILIT, a loan note or contract specifying the loan terms, and a collateral assignment if the policy is pledged as security for the loan.
Choosing private financing can reduce or eliminate gift taxes if the insured is using annual gift tax exclusions in another gifting program, or doesn’t have sufficient gift tax capacity to buy enough life insurance. It may also enable the insured to take advantage of low Applicable Federal Rates (AFRs). Other benefits of private financing include no need for collateral deposits to secure the loan and flexibility in borrowing (either as a lump sum or annually) and repayment (at death or over the insured’s life).
There are a few disadvantages to private financing. Loan repayments may be subject to estate taxes if the insured is the lender, or subject to income tax if the lender is a non-grantor trust or business loan interest. Also, there must be sufficient cash flow to make loan repayments.
Following are some common questions and answers about private financing:
How is loan interest paid?
The ILIT can pay interest from other assets or borrow or withdraw cash value from the policy to pay interest. Or, interest can be accrued and added to the loan principal.
How is the loan balance retired?
There are several options. For example, the death benefit can be used to repay the loan after the insured dies. ILIT assets other than the life insurance policy can also be used, assuming there are other assets. If policy cash values exceed the loan balance, these can also be used to repay the loan, although this may jeopardize the policy’s long-term future and reduce the death benefit.
Are there different AFRs and when are AFRs published?
There are four different types of AFRs: short-term, for loans up to three years; mid-term, for loans of between three and nine years; long-term, for loans of nine years or longer and the blended rate for demand loans that changes every year. AFRs are published on a monthly basis.
What is a demand loan?
This is a loan that’s callable at any time.
What are the tax consequences of private financing?
There are no income tax consequences for the borrower, but there may be income and gift tax consequences for the lender, depending on how the loan is structured. The determination of tax consequences depends mainly on when and how the loan will be repaid. Keep in mind that any outstanding loan balance is included in the insured’s taxable estate. This makes it important for the loan to be documented and administered as an arms-length transaction.
Can using a grantor trust eliminate taxable income to the lender?
Interest payments may not be considered taxable income to the lender if loans are made to a grantor trust. In this scenario, the lender will be considered to have entered into a transaction with himself or herself, so there will be no taxable income.
Is private financing a better strategy than a private split dollar?
It may be for older individuals who need a large, individual life policy and have enough cash or cash equivalents to make a large loan to a trust.
CPA, MBA – President & Chief Executive Officer
About Steve Goodman
For more than 30 years, Steven has provided insightful solutions to the challenges of business succession, wealth preservation and charitable planning, focusing on the needs of owners of closely held businesses and high net worth individuals.
He's been featured in the New York Times and is an accomplished speaker and has presented over the years to many organizations and professional groups on efficient business succession, estate planning issues and tax strategies. Steven is a CPA who was vice president of the Trust and Investment Division of JP Morgan Chase and a supervisor for KPMG Peat Marwick, and holds an MBA from Fordham University.