With the presidential election result finally determined, it’s time to move on and prepare for changes that may be coming. As outlined in our Declaration of Independence, our government was created to protect the unalienable rights of life, liberty, and the pursuit of happiness. That puts each and everyone of us in the role to be personally responsible for our own success and ultimate happiness in life. It’s our duty to do so for ourselves and our families we hold so dear.
To do so requires we stay open-minded to exploring alternatives paths to success that may go counter to what we thought to be true. We can learn from others’ successes but we cannot rely on them to provide it for us.
As we discussed in Part 1, a family bank can be a great way to save for college education, but did you know it can help supercharge your investments?
Here are three important reasons why:
- a) Interest rates are depressingly low on “safe“ saving accounts, CD and Treasuries.
- b) It can be a nice hedge against stock market volatility.
- c) Flexibility. The money you’re borrowing can be paid back on your terms, not on the bank’s terms.
Be a well-compensated private lender
Instead of investing directly in real estate, we have several clients who are using their family bank to make advantageous loans to private real estate investors and developers. Why not invest in real estate directly? Well investing directly ties up their cash. More importantly, they can borrow from their family bank at 4% and loan out the money to other investors at 12%. What’s not to like about a built in 8% spread in which you have to do very little work? Did you know that equates to a 200% return (pay $4 to earn $12…not bad).
And why would the real estate investors turn to private lenders like our clients instead of going directly to banks, where the rate is probably lower? Because loans from private lenders (like our savvy clients) are much faster to approve and simpler to execute, especially if the real estate investor wants to pay cash for a property. There are no mountains of paperwork or burdensome documentation to complete and there’s no drawn-out review process.
For more about private lending see my recent post: How to Win with Real Estate
How a family bank works
You borrow from the insurance company that holds your cash value life insurance policy. The insurer is happy to lend you the money because they have the cash value of your policy as collateral. This way, there’s no surrender period or early withdrawal penalty. The built-in 8% return you earn by lending the money to private investors (12% minus 4%) is considered interest income, not regular income. That way, you’ll be taxed at a lower rate. Even better, you may be able to deduct the investment expense (check with your CPA). You only pay 4% interest on the money you’ve drawn down to loan out. Meanwhile, like a credit line, you can replace the money you’ve borrowed at your own convenience to replenish the policy.
Why use a family bank instead of a credit line or bank loan?
It’s all about control and freedom. By playing the role of the banker, you, your family and your business have more access to funds without having to get an approval from a mainstream bank. The terms are flexible, so you can repay on your schedule and the life insurance company cannot say NO. By contrast, banks have full discretion to set the terms and can deny your request for any reason. Another important benefit is that the cash value within your policy is growing uninterrupted (and tax-free) since you’re not actually using the money. It’s like having a home equity loan–except the cash value and the life insurance is never at risk of going down in value like a home can.
You can also use a family bank for your own investments, as well for lending to your business.
What kind of growth rate is reasonable to expect from the equity portion of your cash value policy?
For the cash value in the whole life policy, there are guarantees within the contract for cash value and the dividends are not guaranteed. Historically returns have been in the 3.5% to 5% range. Earnings are tax-deferred and can be tax-free if never withdrawn. If you factor in taxes, potential management fees, and the term insurance you would need to purchase otherwise, it’s the equivalent of a 6% to 8% return in a taxable account.
By the way, this doesn’t factor in the disability protection and tax-free death benefit you receive or how you use the money while the cash value in the policy continues to grow. The possibilities for using the money are infinite, since there are no rules dictating where the money can be allocated. The only term of the loan is the interest rate. If you die with an outstanding loan in place, a portion of the death benefit will pay for the loan and the balance will go tax-free to your beneficiaries.
Considerations
Startup costs are the biggest hurdle you have to overcome when starting a family bank. You have to fund the “bank” with your own capital before you can start lending it out or borrowing it. But, with a properly designed policy, you can utilize the money much faster than you can with a typical whole life policy, since cash can be made available in Year One of the policy. This doesn’t happen with a typical policy design. It will take a few years to get your policy to the point at which the cash value grows by more than the annual contribution. It’s a long-run strategy and process and you need to think of it this way.
Getting started
Before you even worry about how you’ll capitalize your family bank, you’ll need to show you are in good health. Some insurers will require a medical exam and blood work depending on age and desired death benefit. You will also need to show proof of income and assets.
Conclusion
Family banks provide great protection for your family and your business while providing great flexibility and access to cash on your terms–not the bank’s. Plus, you have the tax benefits of storing wealth inside a vehicle that doesn’t lose money and that can grow uninterrupted while still using the dollars for investments. What’s not to like?
