Funding Life Insurance with Home Equity

Home EquityI had an interesting conversation with a client the other day. He suggested he use his home-equity to fund an insurance policy. While I never recommend this strategy (there have been many lawsuits for this exact strategy) in some circumstances it can be financially smart.

That being said, there are certain things to be aware of.

Apart from the fact that it needs to make financial sense, meaning you need to be coming out ahead in some way, there are a couple of things to be aware of when it comes to utilizing home equity to purchase life insurance.

The Proper Life Insurance Policy

I will not go into too much detail here, but when you use home equity to fund a life insurance policy, it’s important to use permanent life insurance that does not involve risk. Universal Life, Variable Life, and Indexed Universal Life all have risk. The primary risk here is increased insurance cost since these policies are nothing more than term insurance with an investment component.

In short, I recommend nothing but a dividend paying whole life insurance policy. Most lawsuits dealing with home equity and life insurance have involved life insurance policies that were other than dividend paying whole life insurance.

Assessing Your Cash Flow Needs

If you decide to utilize your home equity to fund your insurance policy, you will need to have the cash flow to do so. Just because the outcome might look good on paper, it may not be feasible with the new cash flows.

It’s a serious concern to not be able to handle your new cash flow situation since this strategy will take at least 7 years to be fruitful. You could essentially lose the home, which is most likely the most devastating financial situation you could possibly ever face.

How The Government Factors In

The next thing to keep in mind regards Title 26 Section 264 of the Internal Revenue Code, which deals with the interest tax deduction on your home mortgage. If you decide that it is a good idea to utilize your home equity to fund your insurance policy, it is important to understand that it could result in the loss of the interest tax deduction if not handled correctly.

To handle this correctly and keep the interest tax deduction, you need to understand the rule “4 of 7.” The rule is fairly simple, but is not very well known among advisors who promote this strategy. When you utilize home-equity to fund a life insurance contract, four out of the first seven premiums (annual) cannot come from home equity, but must come from some other source. In other words, three out of the first seven annual premium payments may come from home equity, but the others may not. When structured this way, you will be able to utilize your home-equity, and continue to receive the interest tax deduction on your home mortgage.*

The Interest Deduction

The final point I would like to make involves the tax deduction itself. Though the increased interest expense in this strategy results in additional savings, it is important to note that you may not be saving as much as it may appear. For example, if the standard deduction nets you a $10,000 deduction, and itemizing your deductions nets you $12,000 ($5,000 of which is the interest deduction), your additional tax savings only results in an additional $2000 in deductions. You aren’t saving as much as you think.

These are some important items to take into account when considering the use of home-equity to fund your insurance policy, and is not always advisable.

I recommend taking a look at our Info Kit to learn more about life insurance, and what type of investment it is.

*We are not offering tax advice. Consult your tax advisor.

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Jake

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