Albert Einstein was right to call compound interest the eighth wonder of the world. Like the atom, it can accomplish powerful things. Two things are true about compound interest: It works best (a) over time, and (b) if you leave it alone. The concept of the interest earning interest on interest earning interest is the simple reason why the rich get richer. It’s an immutable law of finance.
If you stop and think about it, whether we know it or not, we finance everything we buy. “But wait a minute,” you say. “I pay cash for everything I own.” Really? The cash you pay could be earning interest if you had kept it, couldn’t it? So by forfeiting that potential interest, you essentially financed it, right? If you paid cash, you have to make payments to yourself to get back to where you were before you made the purchase.
The Infinite Banking Concept® is one rapidly growing in popularity among those whose goal is to create wealth for themselves instead of creating more wealth for the lending institutions. The concept was developed by Nelson Nash, who is also the author of Becoming Your Own Banker. The intent is to provide foundational financial wisdom that will help consumers understand personal finance and partially recover the interest they needlessly give to financial institutions – and on a tax-free basis! Once cash value has been established in a life insurance instrument, such as the one used by the Infinite Banking Concept,® the portion of the interest you pay yourself back is plowed right back into your account and continues to grow compounded.
Once people understand the wealth-building power behind this concept, they sometimes ask why someone didn’t come up with the idea sooner. Nash makes the observation that the underlying contract of a whole life dividend paying life insurance policy has not fundamentally changed in over 100 years.
“This contract is central to the entire system,” says Nash. “So, the concept of how to convert that contract into a tax-advantaged vehicle with similar transactional mechanics of the banking process is what has been developed.”
Nash adds that the Infinite Banking Concept® is not a “get rich quick” concept, but rather a program that requires a commitment of long-term discipline to save. Even Nash acknowledges that it is a major paradigm shift for most folks. It may require a few sessions with a financial professional who is fully trained in the concept and is able to explain it thoroughly. But, once understood, the idea can save the farsighted consumer thousands, if not hundreds of thousands of dollars.
The Private Reserve Strategy™ is another concept that gives us a new way to look at how money works. Developed by insurance industry spokesman and software creator Don Blanton, the strategy is designed to teach people how to avoid what Blanton calls, “unnecessary wealth transfers” where possible and accumulate an increasing pool of capital that you can access and control.
What Type of Account Should You Use?
What type of account should you use for your private reserve strategy? The idea is to use an account that offers you the greatest number of benefits and where your money is available to you through collateralization. Optimally, the account would incorporate the following benefits:
Tax deferred growth. Compounding interest in a taxable account, such as a CD or a regular savings account, is not going to serve you well.
Tax-free distribution. To be able to get the money out without having to pay taxes on it would be awesome!
Competitive rate of return. During the accumulation phase you want the interest to be as high as possible.
High Contributions. Some accounts come with contribution limits. You want to be able to put as much as you wish into the account.
Deductible contributions. This would be highly preferred.
Collateral opportunities. This is key for the private-banker strategy to work. Otherwise, how will you be able to leverage the two accounts?
Safe Harbor. You want the money in the account to be safe.
No-loss provisions. You want to be immune from losses.
Guaranteed loan options. If you are going to collateralize loans from time to time, you’re going to be able to do it at your discretion with guaranteed access.
Unstructured loan payments. This would be preferred. You do want to pay the money back, but you are not under any obligation to do so under a set and rigid schedule, thus eliminating the pressure of forced payments.
Liquidity, use and control. You will want liquidity, use and control of the money at all times.
Additional benefits. It would be nice to have your account protected in case of a lawsuit or an attack by creditors.
So where can you find an account like that? You certainly won’t find it advertised by your local bank. That would be tantamount to the oil industry advertising solar power.
There are perhaps several accounts that will enable you to leverage compounding interest against an amortized loan, but none that I know of that will provide you with all the attributes listed above in quite the way life insurance will. Please know that I’m not talking about life insurance as you probably have always thought it to be – a payment to a beneficiary when someone dies. This is a concept that uses the tax advantages life insurance enjoys courtesy of Uncle Sam and the IRS, and the cash growth features that only life insurance can legally provide. To fully understand the value of the Infinite Banking Concept® or The Private Reserve Strategy™ may require that you stretch the parameters of your thinking a bit, or, as the popular saying goes, “think outside the box.”
The kind of life insurance the concept uses is not the typical term life policy or traditional whole life policy, but a high cash value type of policy designed especially for this purpose. This kind of life insurance is probably the least understood of all the financial tools we have at our disposal. A historical dividend study from Mass Mutual displayed actual internal rates of returns between 1980-2008 of 4.5-6.5% per year average over the 28-year period.
Terms are flexible. You can put as much or as little into your personal bank as you want. The growth is guaranteed and is not subject to market fluctuations. You have liquidity, use and control.
These accounts also have liquidity. The money is yours, after all. You should be able to use it any time you wish. In a traditional loan, you have to prove that you are able to pay the lending institution back. This involves credit checks and income verification. Since you are using your own money to collateralize the loan, none of that is required. A life insurance policy has no restrictions in that regard. It’s as simple as telling the insurance company how much you want to borrow.
Recovering Opportunity Cost
Blanton makes the point that every dollar we do not save is consumed and lost forever. You may be able to replace it with future cash flow, but that money you spent is gone forever. That’s not necessarily a bad thing; it’s just the way things are. Take purchasing a car, for instance. Owning an automobile seems to have become a necessity in modern American life. Witness the fact that there are more than 250 million registered vehicles on the nation’s roads. When you buy a car, you lose the amount of money you paid for that car. If you finance the car, you lose the interest you pay on the loan and if you pay cash you lose the amount of interest you could have earned had you been keep that money earning interest. I call that “opportunity cost.”
If you look at car-buying long term, and in the light of how much it actually cost you over time, you may think twice. Let’s say you bought a new car worth $30,000 and you financed that at 6% interest for 60 months. Your monthly payments would be $579.98 per month for a total of $34,799. You would have paid $4,799 in interest in the process. If you are just starting out in life, this will not be the only car you will ever own. For the rest of your adult life, you will probably own and drive a vehicle. Let’s say that you have 40 more car-buying years left, and that every two years you trade cars and finance the purchase. That’s 20 cars over the next 43 years. Assuming you could get 6% interest on money you saved, if you were able to only invest the interest you paid on those loans, you would have earned $463,203.
“What if I paid cash for the cars?”
Keep in mind, even if you paid cash, you still had an “opportunity” cost. “Either way, it works out to be the same,” says Blanton.
Three Ways to Make Major Purchases
According to Blanton, there are three ways to make major, capital purchases like automobiles.
Going in debt. You may not have a choice. Millions of Americans don’t, and that is what keeps the wheels of the banking industry turning. Debtors aren’t earning any interest, so they are forced to pay interest.
Save up for it. Saving up for something in order to pay cash for it is an admirable discipline. Savers earn interest on their savings dollars and then pay for the purchase outright. Paying cash is better than borrowing money, but you still have to pay yourself back in some way or another. Then there’s the third way:
Collateralize. This method is used by individuals who could pay cash for the purchase, but they understand that second principle of compound interest: it works best if left alone to grow. These are the ones who earn compound interest on their savings and they collateralize their major purchases. This is the method most conducive to creating wealth. Collateralization simply means to pledge a portion of one’s money as security for an amortizing loan against one’s cash purchases. That way, your money is still earning interest while you are paying interest.
An amortized loan, sometimes called an installment loan, is where monthly payments are applied first toward reducing the interest balance, and any remaining amount is applied toward the principal balance. As the loan is paid off, a progressively larger portion of the payments goes toward principal and a progressively smaller portion goes toward interest.
The Zero Line
To analyze this type of financial thinking, imagine a line going across the page we will call the zero line. It represents the financial position of someone who has nothing and owes nothing.
Going into debt. When someone has no money but still must make a purchase, they are forced to borrow against their future income. That forces them to go below zero to a certain point. Draw a straight line downward from the zero line to the debt amount. Now draw stair steps leading back to the zero line to represents the payments made by the debtor to get back to zero when the loan is paid off. If you are like most people in this category, now the process begins again. It’s easy to get trapped in this endless cycle.
Saving up for it. Then there are those who save up for the item and pay cash. This method postpones gratification by essentially making “savings payments” above the zero line until they have accumulated enough to buy it with the cash. Draw stair steps representing those “savings payments” up from the zero line. Then the day comes to make the purchase. Now draw a straight line back to the zero line. That represents draining the tank to buy the item. The saver doesn’t like being that close to the zero line, so they begin saving again until the next needed item must be purchased, and they drain the tank and the process starts again.
Collateralization. – Those who create wealth have been saving just like the savers. But when it comes time to make a purchase, they borrow against their capital and pay off the lender while they continue to compound interest on their money. They made the same purchases as the other two, and they paid off their loans, just like the debtor and the saver, but the wealth creator earned the benefits of compound interest along the way. Draw a line continuing to climb, year by year, far above the zero line.
The Problem with Debt
Blanton describes debt as the act of borrowing money to buy things that you can’t pay for in full with your monthly cash flow. A debtor is someone who has the intention to repay but does not have the ability to pay in full at the time of the purchase. The problem with debt is you have a future obligation against your earnings that you may or may not be able to fulfill. You not only lost the money you spent, but you had to pay interest to get it. When you go into debt, you essentially lose control of your cash flow. You have no control over the money you are spending to repay the debt. Repayment is forced upon you by terms of the agreement. Debt is not an efficient purchasing strategy.
The Problem with Paying Cash
Paying cash means you have to drain your savings – money that was earning, or had the potential to earn, compound interest. Depleting the savings means that you had to reset the compounding. The way compounding works puts me in mind of the old steam engine trains. They left the station slowly, chuffing great puffs of smoke and steam. They picked up speed slowly, but once they got moving, they moved faster and faster, using less energy to do it. When you reset compounding, you lose that initial momentum you worked so hard to build up. Think of the zero line again. For cash payers to truly get back to where they were before they drained the savings tank, they have to put back not only the amount they borrowed, but the interest they would have earned as well.
Another factor is taxes. In most accounts, any money earned is taxed either while it is in the account or upon withdrawal. Remember, compound interest works best over time and when it is not interrupted. Paying cash is not bad, but it’s not the most efficient purchasing strategy.
The Future Effect of Paying Cash
Any time you drain the savings tank to pay for a substantial purchase with cash, you are resetting the compounding process. Paying cash keeps us from paying interest, true. But we still lose the interest we could be earning. Look at the long-term view. Say you have $50,000 in an account earning 5% compound interest. If you leave it alone, you will have $216,097 in 30 years. But let’s say you had a major purchase you needed to make, so you drained the tank of the entire amount, but you put the money back within four years. The compounding momentum that you lost was costly indeed. The restored $50,000 account will only grow to $177,784 in the next 26 years. Big difference!
Why Not Be Your Own Bank?
One concept that successful wealth builders employ is to, in a sense, serve as their own lending institution. Wait a minute! Wouldn’t that “rob the bank,” so to speak? How would the banks make a profit if we were to stop paying interest to the bank and pay it to ourselves instead? That’s just the point! This is a unique way to solve your need for capital while you are saving for your future. Here’s how it works: Imagine a large piggy bank that represents an account with money in it. Call it “My Bank.” Let’s assume you want to make a major capital purchase, such as buying a car. Rather than draining your bank to do it, you secure a loan from a financial institution against the money you have in your bank. The lending institution gives you a check for the amount you want to borrow and you make your purchase. You now have an amortizing loan with the lending institution and they have a collateral position against your private bank. You will pay the institution declining interest while your private bank is earning compound interest. You are leveraging the difference between amortized payments and compounding interest only if the interest rate is higher. The most important thing is that you have liquidity, use and control of your cash and the compounding isn’t interrupted.
To illustrate the difference between amortizing and compounding, let’s say you have a $30,000 car loan on which you are paying 5% interest over a five-year period. Your monthly payments are $566. At the end of the five years, you would have paid $3,968 in interest. If you had $30,000 in an account earning 5% compound interest for those five years, you would have earned $8,501, while you were paying $3,968 in interest through the amortized car loan. However, you would have to use your future cash flow to pay down the car loan and that means you would lose the opportunity cost on those payments in the future.
What about mortgages? If you were to buy a house for $300,000 and pay cash, the cost over 30 years would be $1,340,323 in lost interest, assuming a 5% interest rate. If you finance $300,000 at the same 5% rate, the cost is going to be the same. The principle is the same even if the amounts you are dealing with are higher. Giving up your cash and the access to it is not the best alternative if you are able to leverage your own assets, earning compound interest while paying off an amortized loan.
Taxes and Cash Value Life Insurance
One of the few remaining legal and legitimate tax shelters left is cash value life insurance. There is a minimum one can pay for a given amount of insurance coverage for a specific age. Who determines that? The insurance company, naturally. They will tell you how much you must pay for indemnity on which they bear risk. Insurance companies and their actuaries calculate the least amount of premium they can charge and still make a profit. But is there a maximum you can put into a cash value life insurance policy? Yes. The government will tell you the maximum you can put into it. Why? Because of the tax advantages life insurance provides. Essentially the government has decided the upper limit of tax advantaged growth they will allow you to have. That tells me that it must be a good thing, if the government regulates it. If you buy more life insurance than the limit set by the government, it becomes what is called a Modified Endowment Contract (MEC) and is no longer tax advantaged.
Before the 1980s, there were no such restrictions in place. But the government essentially “drew the line” with two laws: the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) and the Deficit Reduction Act of 1984 (DEFRA). Prior to TAMRA and DEFRA, people were able to put unlimited contributions in a life insurance policy and enjoy the tax benefits that went along with it. This was counter to the wishes of Uncle Sam that Americans sink their savings dollars into tax deferred accounts, such as 401(k)s, IRAs and SEPs.
Why would the government care? Because deferred taxes is a good thing for the tax collector. Taxes that are deferred are merely taxes postponed. Recently, I used an illustration of a farmer opting to pay tax on the seed instead of the harvest. The government knows what it is doing when it defers taxes. The IRS is in essence offering to let you pay tax on the harvest while giving you the seed tax free. They want your tax-deferred account to grow, just like a crop in the field, and when you when you withdraw the money you will be paying them more tax than you would have before. That’s why the concept of Roth IRAs was such a welcome sight for tax savvy investors. With the Roth, you fund the account with dollars that have already been taxed and there is no more tax to be paid, ever!
Cash value life insurance is like a giant Roth in that respect. The money you put into the program has already been taxed but it grows tax-deferred and you can withdraw it tax-free.