What Is Cash Flow Banking?

A couple goes over paperwork in their home.
•••

shapecharge / Getty Images

Cash flow banking refers to using participating whole life insurance policies, which are issued by mutual life insurance companies, to “grow wealth.” The idea is that the cash value in the policy can more quickly accumulate, relative to other types of life insurance, through the strategic use of dividends, and that the policy owner can access funds on a tax-advantaged basis via ultra-low interest rate policy loans.

However, cash flow banking is not without its drawbacks. This article takes a closer look at what cash flow banking is, how it works, plus its advantages and disadvantages.

Definition and Examples of Cash Flow Banking

Cash flow banking is using a whole life insurance policy that pays dividends to build the cash value, then borrow at superior interest rates using the policy’s cash value as collateral. People who use this strategy reinvest dividends issued by the mutual life insurance company back into the whole life insurance policy through the use of paid-up additions. This allows the cash value to build more quickly.

Permanent life insurance policies have an internal cash account called a “cash value,” which grows over time and accumulates on a tax-deferred basis. It can be accessed via direct withdrawals and policy loans.

Once the cash value accumulates to an amount sufficient to borrow from, policyholders can take what’s called a “policy loan.” Importantly, they don’t borrow directly from their own cash value; rather, they borrow from the insurance company’s general fund using their cash value as collateral. This is important because the amount of funds they borrow is still sitting in their cash value account earning a fixed rate of return and dividends.

In other words, if the cash value earns a 4% interest rate and the policy loan is at 5%, the policyholder is effectively paying 1% to borrow those funds. Loans are virtually guaranteed—there’s no application process.

  • Alternate name: Infinite banking

Cash flow banking may be a strategy most suitable for those who also have a need for permanent life insurance.

How Cash Flow Banking Works

To be effective, cash flow banking relies on four things:

  • The ability to supercharge the cash value by reinvesting dividends
  • The ability to leverage that cash value by using it as collateral for low interest rate loans
  • The regular and timely payment of sufficient premiums
  • Time

Reinvest Dividends

All permanent life insurance policies are designed to have a cash value that grows on a tax-deferred basis and is credited interest. The specific interest rate credited depends on the type of life insurance policy, the company, and current market interest rates at policy issue. In the case of whole life insurance, the interest to be credited is determined at the time the policy is issued. But some policies have an added feature that can grow the cash value more quickly: dividends.

Dividends are frequently issued by mutual life insurance companies on whole life insurance policies. You can usually choose to receive dividends in cash, use them to reduce premium payments, let them accumulate in an interest-bearing account, or use them to purchase paid-up additions (PUAs) of life insurance.

Dividend payments are not guaranteed, although you can look at a life insurance company’s dividend-paying history to see how consistently it has issued dividends in the past.

To benefit from cash flow banking, you would reinvest dividends into the policy by purchasing paid-up additions of life insurance. These are like small packets of life insurance on which no ongoing premiums are due. Each has its own death benefit and tax-deferred cash value, and each can earn yet more dividends.

By padding your original policy with paid-up additions of life insurance, you can increase your overall death benefit and cash value, making you eligible for yet more dividends and more cash-value growth.

Many mutual whole life insurance policies offer PUA riders, which allow you to purchase paid-up additions with additional premiums, thereby growing the policy even faster. To maximize the cash flow banking strategy, you would purchase a PUA rider at policy issuance.

Leverage the Cash Value

Another important element to cash flow banking is the ability to borrow money at very low interest rates. This depends on two factors: having sufficient cash value and a low effective interest rate.

The sufficient-cash-value part of the equation is, ideally, addressed through the regular addition of PUAs plus the consistent payment of sufficient premiums. Getting a low effective interest rate is often a general feature of life insurance policy loans. When you use your cash value as collateral for a policy loan, the funds you receive don’t come out of your cash value, but from the life insurance company’s general fund. So the amount you borrow is still sitting in your cash value, earning a fixed rate of return. In turn, that rate of return reduces the interest you pay on the loan. Interest rates on policy loans typically won’t exceed 8%.

Policy loans have the added benefit of typically not requiring an application or credit chec; if you have the funds in your cash value, the insurance company knows you’re good for the loan. They also do not have a set payback schedule.

However, if you don’t finish paying back the loan, the life insurance company will reduce the death benefit when you die by the amount you owe. Plus, your insurance company may credit dividends based on your accumulated cash value, and it won’t be reduced by taking a policy loan (as long as you make sufficient payments on the loan).

Policy loans, if not managed properly, can reduce your cash value and/or cause your policy to lapse, which may have significant tax implications.

Pay Premiums

Whole life insurance policies generally require that premiums be paid consistently and on schedule to prevent the policy from lapsing. To benefit from cash flow banking, regular payment of sufficient premiums is also required to build the cash value and purchase paid-up additions via a PUA rider (that purchases dividends with extra premium payments).

This can make the cost of whole life insurance prohibitively expensive for some people—especially for people who have health conditions, smoke, or are older. This is because the cost of life insurance depends on how long the insurance company expects you to live for. Since smokers and people with health problems, on average, have lower life expectancies, they pay more for life insurance.

If you have health issues or smoke, your cost of insurance may be too high for cash flow banking to be an effective tool for savings and loans.

Time

Since the ultimate goal of cash value banking is to build wealth, it’s important to realize It can take several years to build a cash value that’s larger than the sum of the premiums you’ve invested—even when you reinvest dividends in paid-up additions of life insurance and purchase paid-up additions via a rider.

Consider that whole life insurance policies credit the cash value with a guaranteed fixed rate that may range from 2%-3% for newly issued policies, although the non-guaranteed rate may be higher. Also remember that a portion of your premium goes toward paying your cost of insurance and the cost of any riders added, such as a PUA rider. In other words, only a portion of your premiums will be credited. This is why, initially, you’ll see a negative return on your “investment” if you don’t also have a life insurance need.

Over time, the cash value accumulates on a tax-deferred basis as a result of paid-up additions and interest credited to the cash value. It may grow to be substantially more than the sum of your premiums—although this could take 15 to 20 years or more.

Since time is an essential element to allow the cash value to grow, it’s ideal to wait several years to take policy loans. This is because any policy loan you take effectively reduces the rate of return you receive on your cash value amount, which could delay its accumulation and your realization of gain via the cash flow banking method.

Potential Drawbacks

For all its charms, cash flow banking has plenty of pitfalls.

  • Cost: Permanent life insurance policies tend to be the most expensive form of life insurance, and the addition of one or more riders increases that cost. Since cash flow banking relies on healthy contributions to the cash value via sufficient premium payments and the use of a PUA rider, it will be more expensive than many other life insurance policies for the same amount of death benefit.
  • Best for healthy individuals: The more expensive your cost of insurance, the less your premium will contribute to your cash value. Since accumulating a cash value that earns a rate of return and dividends is key to cash flow banking, it may not be suitable for people whose cost of insurance is high, such as smokers and people with serious health conditions.
  • Best if you need life insurance: If you don’t need life insurance and are simply looking for a long-term tax-deferred or tax-free investment, there may be better options, like setting up a solo Roth or traditional 401(k) if you’re self-employed.
  • Mismanaged loans can cause the policy to lapse: Policy loans, although they use your cash value as collateral, are still loans. If you don’t make interest payments, they could potentially reduce your cash value and cause your policy to lapse. This means the policy no longer exists and could result in tax consequences.

If the amount of policy loans you have outstanding exceeds your policy’s cash value, the insurer may terminate your policy and use the cash value to pay for the loans. And if your accumulated cash value exceeded the amount of premiums you paid into the policy, you may owe taxes on that amount.

Key Takeaways

  • Cash flow banking is a long-term strategy designed to build wealth inside a life insurance policy that can be accessed on a tax-advantaged basis.
  • Participating whole life insurance policies are used for this strategy because they pay dividends that can be used to increase both the cash value and the death benefit.
  • This strategy works best for healthy people who are likely to have low life insurance costs.
  • Cash flow banking is not for everyone; at minimum, you should have a life insurance need if you’re considering this strategy.

Frequently Asked Questions (FAQs)

Who offers cash flow banking?

Cash flow banking is a strategy you can use with whole life insurance policies issued by mutual life insurance companies, such as New York Life and MassMutual.

What is a typical dividend for a whole life insurance policy?

Dividends for whole life insurance policies are credited based on the accumulated value in the insurance policy and on the company’s investment results, which correlate directly to current interest rates. For example, if AAA bonds yield around 3% interest, a typical dividend might be around 5%.