Why it works
There are two concepts at the heart of the Bank on Yourself concept, the LEAP concept, Be Your Own Banker, Infinite Banking, or any of the other systems. The first is the concept of the mutually-owned life insurance company. This means that it’s policyholders who own the company, rather than corporate shareholders. The ‘co-op’ ownership structure means that profits go to policyholders – boosting the returns in cash value policies – and subsidizing the cost of term policies.
Under current tax law, dividends paid to life insurance policyholders are tax-free, which means the after-tax returns on policies participating in the profits of the insurance company.
The second engine driving the concept, again, is a concept little understood outside of insurance circles. The concept is direct recognition – or more precisely, the lack of it. Here’s how it works:
When a life insurance company practices direct recognition, they only pay dividends on the cash value left in a policy after any loans are taken out. If you have $100,000 in the cash value, and you borrow $50,000 against the policy to buy a car, the insurance company will only pay the guaranteed crediting rate and dividends on the $50,000 left over.
But that’s not the only way to skin a cat. Some insurers do not practice direct recognition. They charge interest on the loan, yes – but they do not stop paying the crediting rate and dividends on the money you borrowed against.
That difference is key: When you borrow money against a life insurance policy, you are not really borrowing your own money. You are borrowing from the general fund of the life insurance company – and using the cash value in your policy to secure the loan. This is the logic behind the policy of not practicing direct recognition.
A policy that does not practice direct recognition allows you to arbitrage the difference between the minimum crediting rate on cash values, plus dividends on one hand, and the interest rate the insurance company charges on loans, on the other, to create a source of very cheap credit. It’s probably not free money – unless dividends that year are unusually high. But it does mean that if the dividend rate is 5 percent and the interest rate is 6 percent, your cost of capital is now 1 percent. This doesn’t happen with companies that practice direct recognition. But with non-direct recognition companies, it does. It just takes a while to get to that point.
And there’s the heart of the infinite banking concept, right there: A cheap source of liquidity or finance, available without a credit application and no paperwork. You don’t have to pledge your home, and you never have to pay back the loan. The insurance company pays itself out of the death benefit, if need be, plus interest.
However, it works better if you do pay off the loan, so you can take advantage of the cheap financing again and again. Eventually, you can draw down your cash values to supplement your other sources of retirement income. The whole kit-and-kaboodle is treated by the IRS similarly to a Roth IRA: Funded with after tax dollars, but growth and income taken from the policy is tax free (provided you didn’t blow it by contributing more than the maximum allowable premium for the death benefit – turning the policy into a modified endowment contract.