The Ultimate Debt Hack
Updated: Jan 29, 2020
Hey, welcome back this month. This is Daniel Rondberg from Retirement Research Foundation. This month I'm talking about a common problem I see amongst families, which is somebody in the family borrows money from somebody and now they're stuck with this loan. Maybe they're making payments on it, maybe they're slow paying it, but there's a better way you can structure this amongst your family. I'm talking about that this month. All right. Welcome back. I want to talk to you about something you've never heard before, a way for families to structure debt amongst themselves. It may be a little creative and you've never seen before. I want to tell you a story about a lady that walked into my office recently. She had a scenario where a daughter of hers had borrowed some money to refinance some high interest credit card debt. The daughter hit on some hard financial time.
She was slow paying her mom, not quite making monthly payments every month. Not only was she not able to refinance all the debt, the mom was actually still a co-signer on part of the high interest debt. The daughter was barely making the minimum payment. I mean, it was never going to be a scenario where they'd pay that thing off. Meantime, the mom's out of money because she loaned the daughter money to help refinance some of the debt. The daughter's slowly paying her back. The mom's still on part of the other loan, which is at high interest, and impacting her credit and her ability to borrow and things like that. The daughter's not getting anywhere near paying these things off. What do you do, right? You have a high interest scenario. The mom's out money, the daughter's out money, nobody's happy, right? Everybody's not enjoying that situation.
Well, I want to talk to you about something that I call a secured loan alternative. Now, that is not the proper term for this strategy because there is no term for the strategy. I've never found one. I've used this for many, many years for myself, but it's something I want to share with you. I'm telling you a story about a scenario that can happen amongst family members who want to implement this as well. The mom comes in my office, tells me about this story. Now, she also tells me about her savings account, which she has that's not earning hardly anything. She has well beyond her liquid needs and she's got a surplus of money that's just sitting in a little online money market earning 2%. Now again, online money market at 2% is not bad these days, but she's not happy with the its earning potential. Now, at the same time, this mom also has a need for some potential life insurance.
She may experience a care event at some point in her retirement as she approaches retirement where she would need money to help take care of her if she became permanently disabled. Again, I'm painting a picture here because there's a solution that nobody's thinking of, and I want to pause the scenario right there. Let me recap where we're at. Daughter's on a high interest loan she's not able to afford that's co-signed by the mom. She also owes money to the mom directly. She really has two loans, one directly with the mom, one with the lender that the mom's on the hook for both. The mom has these two loans outstanding, has surplus money in the bank, and has additional needs in her retirement for potentially life insurance and maybe a benefit for care. Very complex scenario, right, but a fun problem to solve.
Enter in a fun scenario that I like to draw up and structure using life insurance. You go, "Whoa, wait a minute. Time out. Where did that come from? Why would you ever use life insurance in this scenario? It doesn't make any sense." Well, I'm going to take you back to a video I did called Becoming Your Own Banker a few months back where we talked about something called the participating loan feature from life insurance. This is so hard to understand. I really want people to get this, and it's so important that you understand it if you're ever going to consider using life insurance in your portfolio for a need like this.
It basically just says this, when you have this participating loan feature, when you take money out of your life insurance policy through a participating policy loan, you are going to get to use your money for whatever you need it for, but it's going to participate in the interest that the policy can potentially earn. Now, there's an interest cost going against the money pull out. For example, let's say you have $100,000 in the life insurance policy. You pull 50 out. There is a maybe 4% interest rate assessed against the $50,000, and then anything you earn can credit up and above that 4% potentially. You can pull your money out and use it and earn interest on it while the policy still thinks it's in there. Let me say that another way so you can understand it. You can essentially borrow your money out, and instead of losing the interest potential, it could make, still potentially get interest on that money.
Pretty cool strategy, right? People go, "Well, how can they do this?" Well, it's because there's a big death benefit on the back end of the policy where if you never pay that loan off to yourself, they're just going to subtract it from your death benefit, the loan plus the interest and pay your beneficiary that. Here's where this gets kind of creative and exciting. We set up a life insurance policy on mom. Mom puts $50,000 in the policy right away, which creates a modified endowment contract, which means that her earnings are no longer going to be tax free. They're taxable based on her ordinary income, based on the earnings of the policy. Her interest was taxable in the first place. It does not make a difference.
When we set up this modified endowment contract, now it comes with $120,000 worth of life insurance and that $120,000 will also pay out a portion of it if mom gets sick and needs money for care, thereby addressing two of her needs. We got to structure life insurance without her having to pay an annual premium. We got to structure some benefit that would pay out for care without buying long-term care insurance. Her $50,000 goes into the policy and it has a potential to earn interest up and above the savings account. Cool. There's three needs taken care of, but here's where it gets crazy. She can take a $40,000 loan from that policy to pay off the daughter's two loans. Cost mom 4% to get the money out. Mom takes a 4% loan to pay off the daughter's two loans. Now, there's one high interest loan that's gone and the other loan that she was charging the daughter, I think it was like 7% for, is also wiped out.
The daughter is still responsible for making payments. Now, here's where it gets exciting. Mom's being charged four for the loan. She's charging the daughter seven. The other interest was something like 18%. As the daughter makes the payments back to mom, a couple of things happen. One, mom's still earning money on the policy for the money that's loaned out, the $40,000 is loaned out to pay off those two lenders. It's now gone from the policy. She's still able to potentially earn higher interest on than she could in the savings account. I say potential. It's not guaranteed that she would do that, but she may be able to. Now, she's still earning interest on the money the daughter's paying back to mom. Remember, mom is borrowing it at four, daughter's paying it back at seven, there's 3%. Now, daughter was also paying 18% interest, mom's being charged four, probably keep the same delta price, 7%.
Mom's making 3% interest on the loan, plus the potential interest in the policy, plus has long-term... Well, life insurance and a care benefit, not long-term care insurance, but a potential care benefit associated, an accelerated death benefit with the policy for a potential care event that could occur, right? She could attach a long-term care rider to the policy as well, so it could be potentially that. It's not in this scenario, but now she has a lot of needs met. She's off the hook for that high interest loan. She's no longer on there, the loan from her policy is not negatively impacting her credit score, which is nice. Now, let's say daughter is still on hard financial times. Remember, she's slow paying mom. She's paying month to month, some months she can pay, some months she can't, some month she can pay more.
There's a scenario here. Well, the lender doesn't care if daughter's on hard times or not. There's an amortization schedule with that loan. If she doesn't make that payments, they're going to default. She'll default on it and they're going to foreclose on her. There's going to be repercussions to that, could be potential negative tax impacts, could be potential impacts or lien. She could be sued by that lender, right? Mom could be sued by that lender if daughter can't make the payments. Well, what happens with the life insurance policy if daughter can't make the payments? Let's say the daughter never pays her back at all and that $40,000 is now gone. What happens to the life insurance policy? Well, because we've structured it so effectively for mom... Let's say daughter never pays it back.
Eventually over time, the cash value, the $10,000 that's left in mom's policy that she didn't loan out, would actually grow back to the whole $50,000, and over time, if daughter never paid another no dime back to the policy, not only would it grow back to $50,000, but the death benefit and benefit that we paying out for care would continue to grow as well. You go, "Wow, what a crazy idea on how to structure all of these strategies to be met for this one scenario using an alternative, a secured loan alternative, through life insurance." The reason why I call it a secured loan alternative is you can go to a credit union or bank most of the time. Mom could put that $50,000 down, create a secured loan against that asset, and borrow money out at 3-4%.
Well, why would she do that when she could put it in a life insurance policy, get the other benefits associated with it, and if the daughter never paid back the money, it would grow back on its own because of that participating loan feature? Phenomenal benefit and just a great way to structure a solution. There's a lot of scenarios there. Maybe a client or a person or somebody needs one or two of those things. Maybe not all of them. This is where the value of life insurance can come into play. It's $1 doing the job of many dollars. You see, that $50,000 she deposited in the policy, it wasn't just sitting in the policy, it was beating out the earnings need on the liquidity she already had. It was providing life insurance. It was providing a care benefit that could be paid out. It was providing a solution to forgive the daughter's debts.
It was providing a solution to take the liability off mom for the debts. It was the money providing the solution to lower the interest costs on the daughter. It was basically the solution for the whole entire scenario. Again, it provides many, many benefits all for many, many dollars doing the job of... $1 doing the job of many, many dollars. It can provide all those things, and I wanted to bring that up because not many people would think to use it in that capacity, but it has a phenomenal benefit. I want to thank you for joining me this month. It's always a pleasure. If you have any ideas on future videos you'd like to see or anything you'd like me to do in our blog or write about, please feel free to reach out in the comment section below. I'd love to hear your feedback and thoughts.
If you have any questions about what I talked about in this video, please as always, reach out. I'm Danny Rondberg. Thanks for joining me.