Rescuing a Bank Loan from Rising Interest Rates

IUL AS A REFINANCING TOOL IN A RISING RATE ENVIRONMENT 

With the cost of capital increasing dramatically as interest rates have risen, many commercial loans now have terms that are far less favorable, if not punitive. Fortunately, clients with life insurance assets have access to a “refinancing” strategy that can provide relief from higher rates in the near term and a long-term management plan.

• Rising Interest Rates Impact Loan Terms: As interest rates rise, the conditions of commercial loans have become less favorable, often to the point of being burdensome. 
• Life Insurance as a Strategy: clients with cash value life insurance policies can use these as an alternative financing strategy, effectively ‘refinancing’ their commercial loans under more favorable terms.
• 1035 Exchange is a Possible Solution

With the current higher interest rate environment appearing to be more than a short-term phenomenon, clients with significant commercial loans are seeking relief from the interest burden they now bear. While shopping for a more favorable rate can certainly help, the reality is that today’s rates are so much higher than when many existing loans were originated, a slightly lower rate provides remains far in excess of the original loan terms.

The ultimate aim is to free the client from the burden of high interest rates on their commercial bank loans, using the financial tools available through their life insurance policies. 

Paying down these loan balances would certainly provide the interest rate relief clients are seeking, but these loans are often used to fund business expansion or other planning objectives that remain important to the client. Attempting to unwind a strategy designed to capitalize on a business opportunity to pay back a loan will often simply trade one pain for another: The pain of higher rates for the pain of missing out on the business opportunity they were pursuing. Some clients, however, may already own an asset that is perfectly suited to “refinancing” these loans at terms that are far more favorable than even the most well-qualified client can find in the market.

High Rates are here to stay – the higher interest rates are expected to persist, so clients with sizeable commercial loans are looking for ways to alleviate the impact of these increased rates.

THE ASSET? CASH VALUE LIFE INSURANCE.  

This is the very same life insurance policy may have been the actual collateral used to secure the commercial loan in the first place. The available interest rates were far lower than those available on loans from some insurance policies. As rates have risen, however, the best use of the policy cash value may no longer be as collateral. It may be paying off the bank loan. There are two variables that have to be considered when considering the loan repayment: 

1. Is the loan interest rate in the life policy more favorable than the bank loan? Even as bank loan rates have risen, they may remain lower than the rate available on the policy loan. The net cost of the policy loan, however, is likely to be lower based on the policy also receiving some sort of credit on the loan balance.
2. What’s the long-term performance impact of the policy loan? Larger loan balances can seriously impair the future performance of the policy. 

For some clients, the answers to these questions will be favorable and a loan from the policy is a clearly superior option when compared to the terms now available from the bank. Unfortunately, that will not always be the case. Whole Life policies in particular frequently have much higher loan interest rates and large loan balances create a drag on policy performance that results in a risk of lapse in the future. 

1035 EXCHANGE AS A SOLUTION 

There is, fortunately, a potential remedy to the scenario described above. That remedy involves sourcing a new life insurance policy, funded by a 1035 exchange, that offers the low loan interest rate we are seeking and a strategy for maintaining long-term policy performance. In some instances, the client can extinguish the loan balance without having to pay out of pocket, leaving them out from under the bank loan they are currently struggling with and with an adequately funded policy. 

A new life insurance policy with lower loan interest rates can be obtained through a 1035 exchange, which allows for the transfer of policies without immediate tax consequences.

To execute this strategy, there is a proper order of operations, so to speak, that needs to be followed if the life policy was, in fact, used as collateral for the bank loan. Trying to execute a 1035 exchange with the existing policy encumbered by a collateral assignment will typically not work. Instead, the following steps need to be followed: 

• Take a loan from the existing policy first. That loan is used to bay off the bank loan, allowing the bank to release their interest in the policy. 
• Once that is complete, a 1035 exchange to the new policy with more favorable terms can be completed. 

• With the new policy in force, the repayment strategy begins, using annual withdrawals up to cost basis to make loan payments until either the cost basis is exhausted, or the loan is extinguished.

Figure 1: The Bank Loan Refinancing Strategy