Q: Why does the insurance company charge me interest to borrow my own money?

This question is one critics of cash-value life insurance often raise. For them, if the savings accumulated in the insurance policy belong to the owner of the policy, it seems unfair, even unethical, for the insurance company to impose a charge to access the savings. For cynics, these transactions represent a conspiracy to defraud the consumer.

Cash value loans aren’t a conspiracy. They just aren’t understood very well by most consumers – and even some so-called “financial experts.” What follows is an attempt to correct this misunderstanding.

Although the analogy is not exact, a cash value life insurance policy can be understood as being similar to a mortgage agreement. In a mortgage, the borrower assumes control of a piece of real estate immediately, but pays for it over time. At some future point, when the mortgage has been paid, the individual will own the property “free and clear.”

Likewise, a policyholder takes control of a specified amount of money (the insurance benefit), and agrees to pay regular premiums over time. Depending on the type of contract, the life insurance policy can eventually reach “paid up” status, i.e., no more premiums are due, and the owner of the contract holds the insurance benefit free and clear.

There are other similarities as well.

Just as you build equity in your property by making monthly payments on the mortgage, equity grows in your insurance policy as cash value. To compensate the lender for the risk of borrowing, mortgage payments are weighted toward interest at the beginning, so equity grows slowly. Likewise, cash values tend to accumulate slowly at the beginning of an insurance contract. And like the mortgage lender, the insurance company has the biggest risk at the beginning of the policy’s life. If the company agrees to insure you for a million dollars, and you only make three months of premium payments before dying, your beneficiaries still receive the insurance benefit, and the insurance company takes a big loss (because they were counting on collecting many years of premiums before paying the promised benefit).

Another similarity between a cash value insurance policy and a mortgage is the way that equity can be accessed. With a home, the owner can tap the equity through refinancing the existing mortgage, or taking a separate home equity loan.

If your home is worth $250,000 and you owe the bank $90,000 on your mortgage, you have $160,000 of equity in the property house. In this situation, a bank might typically offer a home equity line of credit equal to 80% of the value of the house ($200,000) minus what you already owe in the mortgage ($90,000), or $110,000. To do this, the bank will charge interest on the amount loaned, and will establish a monthly repayment schedule.

If you have followed the discussion from the beginning, and are tracking the parallels between a mortgage and cash value life insurance contract, a question should be popping up:

“If the equity in my home is my asset, why do I have to pay interest to the bank on ‘my money,’ when I take a home equity loan?”

Yeah! If the equity is your asset, why do you have to pay interest to someone else to use it?

Here’s the reasoning for the home equity loan: the interest rate the bank is charging you is an “exchange fee” for converting the value in your house into cash. In theory, you could “spend” your equity by taking pieces of the house and exchanging them for other goods. Two bricks for a loaf of bread. A light fixture for a pizza. But not every grocery store accepts bricks, and not every pizzeria wants light fixtures — like everyone else, they prefer cash.

Not only that, but your house is worth more than the sum of its parts. If you decided to access the wealth in your house by selling it bit by bit, the value would drop significantly on what was left. Taking a home equity loan not only allows you to convert a material asset to cash, it allows you to maintain the ongoing value of the asset, instead of gradually destroying it. You may complain about the rate being charged, but the bank does provide a service in exchange for the interest.

The same financial idea applies to accessing life insurance cash values. The cash value in your policy has a dollar value, but the asset isn’t the same as cash — it’s an insurance benefit. If you want to convert it to cash, and still keep the insurance intact, the company has an “exchange fee” just like the bank, except:

The repayment schedule is set by the policyholder, not the bank.

The insurance company cannot deny access to cash values, although a bank might refuse a second mortgage.

As we said at the beginning, properly understood, a cash value insurance policy is really like a “mortgage” for an insurance benefit. Yet many consumers (and “experts”) who never think twice about how a mortgage works for real estate get all worked up about the same features when they are part of an insurance policy. Yet you probably haven’t ever heard people make this kind of complaint about a home equity loan — and the banks are much more restrictive than the insurance companies.

Understood in this light, it’s possible to see similarities between home equity and cash value loans.

Since there are a wide range of insurance contracts, and your situation is unique, make sure you consult with your insurance professional about suitable ways to use your cash values.

Elozor Preil is Managing Director at Wealth Advisory Group and Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS).  He can be reached at [email protected] See www.wagroupllc.com/epreil for full disclosures and disclaimers.

Guardian, its subsidiaries, agents or employees do not give tax or legal advice.  You should consult your tax or legal advisor regarding your individual situation.

By Elozor Preil