The case
Pricilla, 38, owns and operates a seven-seater taxicab and tour service. The loan that she borrowed to finance this vehicle was repaid two months before time. Last year, she inherited a house from her grandmother but it is in dire need of repairs and could cost up to $350,000.
Loans officer Billy, pleased with her track record, is willing to provide mortgage financing for a period of 25 years at a rate of six per cent per annum. The only condition is that she provides a term life insurance policy for at least $200,000 to cover a part of the loan, in the event of an untimely death.
Pricilla approached her cousin Betty who works at an insurance brokerage firm. Betty advised Pricilla that she could get a $200,000, 25-year term policy with a monthly premium of $125. Betty reiterated that the only downside with the plan was that when it matures, she has nothing to get back. Pricilla was not impressed with that feature and asked if there was another policy that provided cash back in the future.
Betty then took the opportunity to do an illustration of a plan that would provide the same level of coverage the bank required but would also refund all of her premiums at maturity as part of a guaranteed cash payout $200,000 plus a bonus of $150,000. If she dies anytime before the plan matures, the company will pay $200,000 plus a refund of the premiums paid as at that date.
If she becomes disabled for more than six months, the company will keep the policy in force until she recovers or until maturity; whichever was sooner. If, for any reason, she cancels the policy before the end date, a projected cash surrender value will be paid, less any accumulated debt on the account.
Pricilla was excited that she really had nothing to lose and shared the policy benefits with Billy to see if he would accept the alternative as collateral. Billy agreed but expressed his concerns as to why the same coverage was costing $689 more per month and wondered if she could have found a better use for the extra premium.
Pricilla knows the term is cheaper because she has nothing to get back but she cannot evaluate if the extra cost would provide value for money down the road. She is now undecided as to which policy to select and is seeking our guidance.
Nick’s assessment and advice
The policy that Betty has put on the table sounds very good especially the part about getting back all of the premiums whilst still enjoying the insurance coverage of $200,000 for the duration of the plan. In a way she is actually getting free protection if she keeps the plan in force for the contracted period. Even if she cancels the plan, there is something to get back. How much that would be is another question.
The only thing that is a little difficult to come to terms with is the monthly payment of $814 ($689 + $125), which we will discuss below.
Purpose of insurance
In the world of personal finances, it is sometimes easy to deviate from the real purpose of a particular financial instrument. Insurance’s primary function is to offer protection against the financial loss that could occur if a certain peril materialises. It is uncertain why the banker requested only $200,000 coverage for a $350,000 debt. Maybe the bank has its own plan in place that covers part of the debt or maybe Pricilla already has another policy for $150,000.
Be that as it may, Pricilla’s confusion really started when Betty raised the point o.f “getting nothing back.” Pricilla’s attention shifted completely from the primary objective to that of saving and investment.
If her objective were savings and investment, then the cash value policy would have to be evaluated alongside other scenarios or instruments that are comparable in order to make an informed decision.
Savings and investment
This policy has a very tempting future value of $200,000 plus a bonus of $150,000. Of course, this is not free money because Pricilla still has to pay for it and the total cost of doing so is $244,200 ($814 x 12 months x 25 years). She will earn a profit or gain of $105,800 ($350,000 - $244,200). This amount would be even more impressive if we removed the monthly cost of a pure protection plan, that is, the term life premium of $125.
Whilst from an actuarial standpoint this may not exactly be the accurate approach, it might still be helpful for the sake of a rough comparison.
Excluding the term premium component, Pricilla would have invested $206,700 ($689 x 12 months x 25 years) to obtain the same future value of $350,000, giving her a profit or gain of $143,300 ($350,000 - $206,700).
Return on investment
Looking at this return through the lenses of a financial practitioner, the first question is: what was the return on this investment over the period?
When we plug in the numbers using time value of money calculations (monthly payments of $689, period of 25 years and a future value of $350,000) we find that the effective annual interest rate was 3.92 per cent (only if she stays for 25 years); not bad in a world where rates on guaranteed investments is less than half that figure.
The use of the words “guarantee” and “investment” in the same sentence has the power to allay many fears from an investor’s mind. However, guarantees can also be secure in financial scenarios other than the usual savings and investment instruments.
The real value of money
Looking back, it is not too far fetched to imagine that the cost of living can double (100 per cent) every 10 years; the equivalent of a rate of inflation of about seven per cent (6.95 per cent) per annum. This also means that the value of money is moving in the opposite direction of that rate.
A good example is the cost of a loaf of bread. Ten years ago it was $6, today it is certainly more than $12. This means that $6 today would only be able to purchase half (50 per cent) of a loaf of bread.
Applying this concept to the policy’s guaranteed future value we would find that in 25 years, the buying power of $350,000 would be just under $65,000 ($61,276) in today’s terms. What will Pricilla do with that money in 25 years time?
The better use of money?
If Pricilla’s world only consisted of a cash value insurance policy that yielded 3.92 per cent per annum, a piece of real estate that could yield upwards of five per cent per annum; a mortgage interest rate (hopefully fixed) of six per cent per annum and an annual inflation rate of 6.95 per cent, then we could decide on a better use of the extra premium dollars she has to pay.
Whilst it may be impossible to reduce inflation and impractical to buy or improve real estate in monthly installments; it would be sagacious to accelerate the repayment of her mortgage by the extra $689 per month and hopefully without penalty. She could even choose to rework the mortgage installment up front to include the $689.
A 25-year mortgage of $350,000 at six per cent would work out to $2,255 monthly. If she decided to pay $2,944 ($2,255 + $689) the term would be reduced to 181 months or 15 years. If she was prepared to live without this installment for 25 years, then she should be able to save it for the remaining 10 years of her investing time horizon, which is a total of $353,280 not including interest. If we applied a conservative annual interest rate of 1.96 per cent (3.92% / 2) she would see a future value of $389,928.
Additionally, because she would have paid off her mortgage in only 15 years, the interest saved would be $146,580 (see table above). Also, the fact that she only needs the insurance for 15 years, the term policy for $125 could be discontinued after the debt is repaid saving a further $15,000 ($125 x 12 months x 10 years).
Nicholas Dean (CertFa) is a qualified independent financial adviser and is the managing director of The Financial Coaching Centre Ltd. If you have any questions or need advice on today’s subject please email: nickadvice@gmail.com or visit Web site: www.FinancialCoachingCentre.com
