Using Other People’s Money to Create Wealth

We all love the idea of creating something out of nothing but this is usually fantasy and does not exist…right? A famous saying in business is that you should always use ‘Other People’s Money’ (OPM) which is great way to get ahead with no money out of pocket and no personal risk.

There are strategies to create wealth for you and your family using other people’s money in the same way you used the bank’s money to purchase your home or investment properties and that is by using leverage.

Using other people’s money, or leverage, to increase your own financial gain is an established practice. Today, though, leverage is being used to purchase life insurance, and has gotten the attention of insurance promoters and financial professionals. It’s important, though, to examine all the angles before trying something like this.

The technique is called Premium Financing and allows a wealthy family or a corporation looking to create a continuity plan by funding an insurance policy can do it using the bank’s money. By borrowing the money to pay the life insurance premiums with a loan, the insured individual/s free up capital that can be used more efficiently. The use of premium financing may lower out-of-pocket costs the potential gift taxes.

The lender bases the current loan interest rate on the one-year London Interbank Offering Rate (LIBOR), adding a profit margin spread of 175 to 250 basis points. Essentially, lending rates are determined on a case-by-case basis, taking into consideration the loan amount and the lenders’ risk exposure. Loan interest rates can be fixed on an annual basis, but may vary from year to year, based on fluctuations in LIBOR or changes in the borrower’s financial conditions, which must be updated annually.

The twelve-month LIBOR is a common index as well as the prime rate. If there is a fixed interest rate, it is important to determine how long it will be fixed. In many instances, the fixed rate is only fixed for a certain time period, such as five or ten years. A cap will be set on how high the loan interest rate can go during the loan term. So, while the loan interest might be variable, there is a cap that will limit how high the interest rate can grow, such as eight percent.

You can also secure what’s called a “collar,” which is when a loan has both a cap and a floor on the interest rate. It basically keeps the interest rate from spiraling too high but ensures that the lender can charge a minimum in exchange for that security.

Caps are more expensive than collars because caps protect only the consumer, while collars offer some protection to the lender. Because of this, the extra costs are usually built into a loan origination fee or into the amount of spread placed in the offer. Caps and collars are usually only offered on loans greater than $1 million.

The best candidates for premium-financed life insurance typically have a minimum net worth of $5 million. Collateral for the loan usually consists of personal assets and can be reduced by the cash value in the policy being financed.

Plan highlights include:

· Target market: at least $5million estate and minimum of $100,000 annual life insurance premium.

· Frees up business or personal investment capital for more efficient usage.

· Leverages available assets to provide needed insurance coverage with minimal out-of-pocket expenses.

· Potential to reduce gift taxes.

· Loan rate typically tied to a published rate like LIBOR, plus a spread.

· Required collateral can be offset by cash values growing tax-deferred in the policy.

· Can provide substantially greater internal rate of return on the life insurance policy death benefit over non-financed payment methods.

The power of premium financing lies with the same simple concepts related to leveraging of permanent life insurance for estate liquidity and wealth transfer in uncertain financial and political times. It also provides an excellent tool to insurance key executives of a business so that unwanted family members do not become partners. The key is to evaluate premium financing not as a stand-alone transaction, but as an alternative to the traditional funding of life insurance.

I have been involved in cases where it made sense not to drain cash flow and instead use leverage to accomplish payments of the life premiums. If the structure is designed properly, it can have an exit strategy built in. There is also one planning technique for families that have done no estate planning but are uninsurable and have healthy children. This planning tool is too technical to discuss here, but if you’re reading this and know someone who has an illness, no estate plan and over $10,000,000 of net worth, you can have them give my office a call.

James Burns, Esq.

(949) 440-3243