Infinite Banking and Bank on Yourself: Scams or Wise Investments?

A friend was considering buying into "Infinite Banking" or "Bank on Yourself", which is a sort of whole life insurance policy that allows you to borrow on your own money once you're fully vested. At first, it seems like a really cool deal: why borrow from a bank when you could borrow from yourself, paying yourself interest rather than the bank?

But the more I read, I determined that some of the supposed benefits were largely illusory. Yet, the fascinating thing was that, after reading for hours on the subject (and I was always good at Math and consider myself pretty good at personal finance and investing - hey, I wrote an entire book on it!), there was still a mental cloud that hung over it. It's sort of like those mathematical puzzles where Sally buys something, sells something, then something complicated happens and you know you're applying all the right equations, but in the end the numbers always come out wrong. When your mind tries to retrace the steps, it gets lost in sort of a fog.

But in this case, the fog eventually cleared for me. Here are my conclusions that I shared with my friend. Feel free to interact if you're considering this. But you may want to go straight to the Kiplinger site, where a ton of interaction is going on. You can read people arguing pro and con, and eventually you, like my experience, might see the fog clearing up.

Here's the Kiplinger discussion, which any person considering "Infinite Banking" should carefully consider:

http://forums.kiplinger.com/showthread.php?t=10496&page=3&pp=15

During the first pages of the discussion, many of the comments are positive toward Infinite Banking, but as people delve into it more, you find more and more negatives. So make sure to keep reading. This is a ton of money you're considering putting into this, so study it carefully. Remember Solomon's warning: "The fool believes everything he hears."

So here are some of my red flags, concerns and questions I'd ask for someone trying to sell me this policy:

Questions, Concerns and Red Flags

1) What is the name of the insurance company you'd be using? I’d like to see how it’s rated. Here's an authoritative source for rating insurance companies:

http://www3.ambest.com/lh/default.asp

But even if it’s rated excellent, that’s lots of money tied up in one company. If that's where most of your savings is going, you're putting a lot of eggs into one basket. Is it insured by the FDIC? If so, up to what level? What happens to the money if the company goes broke? (Just before Enron went belly-up, it was still given the highest ratings. People didn’t know what was going on inside until the very end.)

2) The Websites for these groups immediately start explaining why Dave Ramsey and Suze Orman are against them, saying stuff like “They don’t understand these policies.” Well, from what I’ve read of Suze, although I don't always agree with her, she's pretty thorough on things, particularly insurance. I’d want to know precisely why Suze and Dave are against this. If you don't understand their criticisms, you don't know both sides.

2) Some are saying this isn’t anything new, it’s just being marketed differently. So, if it isn’t new, then why did the others stop doing it? Maybe it’s something that sells well when the economy is looking bad and everyone is scared, but nobody wants to get in when things are going well.

3) Why aren’t the major insurance companies selling this? Are they? I’d like to see what the big insurance associations say about them.

4) The way this is being marketing looks more like hype than solid information. Look at Pamela Yellen's book, Bank on Yourself in Amazon. So it has almost 100 reviews, and a significant percent are five star. But any author can get lots of associates and friends to write five star reviews, particularly if you're selling a product and have other product sales people under you who have a vested interest in making the book look good. But a significant 12% of the reviews are only one star. I often see this in financial books that have some good stuff in them, but also some crap. Lots of five-star fans, but also a significant portion of one-star critics saying, "This is crazy!" Read these one-star reviews carefully.

http://www.amazon.com/Bank-Yourself-Life-Changing-Protecting-Financial/product-reviews/B003156AXW/ref=cm_cr_dp_hist_1?ie=UTF8&showViewpoints=0&filterBy=addOneStar

My Bottom Lines

1) It’s a type of whole life insurance policy. Don’t get it unless your main reason for doing it is to give money to a loved one at the time of your death. Even then, make sure that it’s a good policy compared to other life insurance policies. Example: how much of all that money you’ve saved actually goes to your beneficiaries in the end?

The vast majority of financial counselors that I read say to buy term insurance (which is much less expensive) and invest what you save, until you've saved up enough to be self-insured. If you're 55 years old and you've got lots of money saved up for retirement, you just need to insure the difference between what you've saved and what your loved one would need if you died. So you need less and less life insurance as you go through life. After you've got enough to retire, you probably don't need life insurance at all.

2) The concept of “being your own bank” and “infinite banking” seems largely illusory. I got fascinated with it and was up till 1:00 AM trying to understand people’s arguments back and forth in this regard. When I woke up the next morning, I suppose my mind had been working on it during my sleep, and it seemed clearer to me. I think the quote at the end of this post will show clearly that, if you need to borrow money, in most cases, you’d be better off just finding the lowest cost loan than borrowing from your own money in your insurance policy.

As an aside, I'm in the habit of saving up and buying things, so that I've never made payments on depreciating assets like a car or furniture. Don't borrow on a depreciating asset. And don't borrow on an appreciating asset unless it's absolutely necessary. Borrowing is sometimes a necessity (a medical emergency or to buy a house), but never safe. Even if you're borrowing from your own insurance policy, "the borrower is the lender's slave." There are consequences if you don't pay it back, and you need to know precisely what those consequences are.

3) In what cases are smart people justifying buying one of these policies. Only in limited situations. Some who argue for the wisdom of such a policy are saying that “it’s not a substitute for your retirement, but if you’ve already got a great retirement set up, and if you’re currently making a high salary, so that you’re not likely to default on your payments, then it may be a way to further diversify the assets that you want to go to loved ones at your death.”

4) Some say that they weren’t saving anything for the future, and this is forced savings, like when you have to make your mortgage payment each month. They say it works for them, but it seems pretty expensive to me. You're paying tons of money for the policy that could be growing in a low-cost mutual fund. And if you’re an undisciplined spender today, then might you also over borrow from your insurance fund and get in trouble trying to pay it back?

5) I’d want to know exactly what happens if you can’t keep up your payments, or if you borrow from it and can’t pay it back on time. And can those rules change over time?

6) I’d want to know exactly how the 5% (or whatever) growth per year works. What is the rate based on - how well the company’s doing? If so, what if this type of policy goes out of favor and new people stop putting money in? Will the percentage increase drop?

7) I'd want to see an exact comparison, all costs considered (taxes, service fees, etc.), of how the money you'd put into a policy like this would stack up against a fairly conservative investment in stocks, bonds and cash equivalents at a respected firm like Vanguard.

8) Some people are talking about paying up these policies with the equity in their houses or using this as their retirement plan. This would be a huge step and makes no sense to me at all. What if this company goes belly up? Again, you've got a lot of eggs in one basket. Sure, stocks and bonds and banks and real estate can be scary. But that's why we diversify. If my stock mutual funds are diversified between thousands of companies, then the worth of all those companies could never drop to nothing, except in an Armageddon scenario. And in an Armageddon scenario, say goodbye to your insurance and the FDIC as well. If you're looking for Armageddon, get your life right with God (for your long-term outlook) and invest in guns and knives (for your short-term outlook).

A Comparison of Banking for Yourself (from your insurance policy) and Borrowing from Your Real Bank

I'm just slightly revising one of the posts from the Kipplinger discussion group. The important thing here is to keep your eye on how much the transaction is costing you out of pocket over time. I think you'll see that in all three cases, you're spending the same amount to borrow the money. Banking for yourself is in reality giving you no real benefit that I can see over taking out a traditional loan.

Example 1: Using CASH for purchase. $10,000 account earning 5% interest.

I take out the $10,000 and make purchase. It is no longer earning 5%. So, after 1 year, I have lost $500 in interest, correct? Well, lets say at the end of the year I put back the $10,000 + $500 ($10500). So, it was as if I never took money out in the first place because I added $500 out of my pocket to make up for the lost interest. The opportunity cost of using the money was 5%, but I made it up by "charging myself" 5%.

This transaction cost me $500 out-of-pocket and I now have $10,500 in my account.

Example 2: Commercial loan. $10,000 at 5% interest

I take a 5% loan from a bank and leave my $10,000 in the bank, still earning 5% interest. At the end of the year, I pay off the loan in full for $10,000 + an additional out pocket $500. My bank account earned $500, but the loan interest cost me $500. The opportunity cost of using this method was 0, but the interest cost of using this money was 5%.

This transaction cost $500 out-of-pocket and I now have $10,500 in my account.

Example 3 (Infinite Banking): Policy loan for $10000, current loan rate 5%

I take a 5% loan from my policy and make my $10,000 of cash value collateral, still earning 5% interest + dividends. At the end of the year, I pay off the loan in full for $10000 plus an additional out of pocket $500 to free up my collateral. My cash value earned $500, but the loan interest cost me $500. The opportunity cost of using this money was 0, but the interest cost that I needed to pay to free up my collateral was 5%.

This transaction cost $500 out-of-pocket and I have $10,500 in my account.

Also, I should mention, I can borrow money on my home equity loan presently for much less than 5%. And some car loans are at 0%. If I "borrow" from my cash account that's getting pitiful interest, like my Money Market fund, then my out-of-pocket opportunity loss would be only about 1% over a year. My point? Even if you had an "infinite banking" account to borrow from, in many cases you'd be better off borrowing elsewhere.

The bottom line? What benefit was it to me to borrow from my insurance policy?