The policy owner borrows the funds. In the majority of cases the borrower will be an entity – either the client’s ILIT or his/her business. In rare instances the borrower can be an individual, but this structure will require prior approval from the program.
The borrower should understand that financed insurance is NOT free insurance and using this method to pay for life insurance may expose the borrower to additional risks that are not associated with traditional life insurance policy purchases. Those additional risks include fluctuations in the loan interest rate, fluctuations in the policy crediting rate, valuation of the life insurance policy, the potential need for additional collateral held outside the policy, and the potential gift tax exposure if the insured is forced to repay the loan on behalf of an ILIT (or some other individual or entity who is the policy owner).
Programs utilize capital from large, highly rated and well-known financial institutions that have pre-authorized a significant level of funds to be used for financing life insurance premiums.
In some cases, clients may elect to rely on their own personal banking relationships for financing life insurance premiums. These clients and their banks will then be solely responsible for establishing the terms and conditions of their financing arrangements.
Loan interest rates are typically based on a recognized benchmark interest rate plus an additional spread. The most commonly used benchmark rate is the 12-month London Inter-Bank Offered Rate (LIBOR), although other rates (i.e., the Prime Rate) may also be used. LIBOR is the interest rate at which banks offer to lend money to each other in the London wholesale money markets. It is a common rate used in global capital markets, and is published daily in the Wall Street Journal.
The spread above the benchmark rate typically ranges between 100 and 300 basis points, and varies by the amount of the loan, the credit-worthiness of the borrower and the collateral that is posted. While the benchmark rate used is expected to fluctuate on an annual basis, once negotiated, the spread typically remains constant for the life of the loan. Interest will typically be charged annually, though some programs will negotiate other durations.
For most loans, the interest rate will change annually, corresponding to changes in the benchmark interest rate. However, borrowers may wish to negotiate a long-term or short-term lock-in period where the interest rate will be fixed. Lock-in rates are subject to market availability and come at a premium.
No, the loan interest in premium financing falls under the category of “personal interest,” and that deduction was eliminated by the Tax Reform Act of 1986.