Infinite Banking: How It Works and When To Use It

If you've ever taken out a loan, you know that it's expensive to borrow money. High interest rates increase costs prohibitively over the lifetime of the loan, even if you're well-qualified. That's the issue that cash flow banking aims to solve — by using insurance as a funding source, this strategy purports to reduce interest and streamline the borrowing process.

What Is Cash Flow Banking?

Cash flow banking is a strategy that involves borrowing against the cash value of your life insurance policy. These loans usually have lower interest rates than traditional loans — plus, you don't need to repay the principal. Since the loan is secured by your policy, insurance providers don't require an application and approval process.

How Does Infinite Banking Work?

If you want to use cash flow banking as a financial strategy, the first step is to find a life insurance policy that accumulates a cash value. Both universal and whole life insurance fit this criteria, but cash flow banking enthusiasts tend to prefer whole life policies that pay dividends. Instead of taking the dividends as income, you can put them back into the policy to build the cash value faster.

Over time — potentially decades, depending on the size of your monthly premiums and dividends — your policy's cash value increases. When it reaches the level specified in your insurance contract, you can take out a loan against the policy.

Infinite Banking: Pros and Cons

As you decide whether cash flow banking is right for you, make sure to weigh the benefits and drawbacks against your personal financial situation.

Benefits of Infinite Banking

If you struggle with traditional lending options, cash flow banking has significant perks:

• No taxes on loans: Life insurance loans aren't typically taxed as income.
• Low interest rates: Loans against your policy usually have low interest rates. Plus, since you're borrowing against the cash value rather than from it, the money is untouched. It continues to grow in your account, effectively reducing the interest rate on the loan.
• Easy approval process: Most providers don't require credit checks or other financial approvals; your cash value serves as collateral. That means it's typically easier and faster to access the cash.
• Flexible payback requirements: Many insurance providers don't require you to repay the balance on your life insurance loan on a set schedule — or at all. As long as you make interest payments on time, you can keep the money or repay the loan on your own schedule. This is a big benefit in an emergency; it enables you to access cash without worrying about immediate payback.
• Growth options: Depending on the policy you choose, you may be able to reinvest dividends or make additional premiums to boost the cash value.

Disadvantages of Infinite Banking

The primary disadvantage of cash flow banking is the time involved. Cash value takes years or decades to accumulate, even if you're maximizing premiums, dividends and riders. Other risks include:

• Premium costs: Life insurance providers typically take your age and health into consideration when setting premiums. If you're older, a smoker or if you have health issues, premiums may be high.
• Limited loan amounts: Your contract may limit the percentage of cash value that's available to borrow.
• Reduced death benefit: If you don't repay the loan during your lifetime, the insurance provider will subtract the remaining balance from the death benefit. This can have a significant impact on the amount that goes to your beneficiary.
• Impact on cash value: Some providers let you deduct interest payments from the cash value in your account. If the interest is higher than the cash value, it could cancel your policy.
• Risks due to policy lapse: If you stop paying premiums on your life insurance policy, or if the interest exceeds the cash value, the provider may cancel the contract. At that point, you might owe income taxes on the outstanding loan amount.

Choosing an Insurance Policy for Cash Flow Banking

Whole life insurance tends to be the preferred option for cash flow banking, largely due to the fixed premiums and option to receive dividends. As you choose a policy, check the minimum guaranteed rate of return. This helps you estimate the minimum growth rate for your cash value. Keep in mind that to balance risk, policies may also put a top limit on gains.

A higher guaranteed interest rate can make a big difference when you take out a loan. If the loan has an interest rate of 7% and your policy grows at a minimum of 2%, your effective interest rate is 5%.

The loan terms are another key factor in selecting a life insurance policy for cash flow banking. Check the contract to find out how long you'll need to wait to borrow against the cash value — many companies prohibit policy loans for 10 years. Then, explore the available repayment options for interest to ensure that they provide enough flexibility.

To maximize cash value, look for whole life policies that offer paid-up additional insurance (PUA) riders. These riders let you use dividends to increase the cash value of your policy; they may also pay dividends themselves. PUA riders expand your coverage without the need for another medical exam, which is convenient if you experience health issues in the future.

When Is It a Good Idea To Use Infinite Banking?

Due to the potential risks, it's important to approach cash flow banking with caution. This strategy is typically a good idea only if you have an existing need for permanent life insurance — if not, other financing options can mitigate risk and help you get access to cash in less time. 

Cash flow banking is a long-term strategy, so it tends to be most effective for younger people. The earlier you buy a whole life policy, the more time there is for the cash value to grow. Plus, premiums tend to be less expensive when you're young and in good health. Since monthly costs are fixed, it's a good opportunity to lock in a low price.

Even if you buy life insurance specifically for cash flow banking, it's important to think carefully before borrowing against the policy. In some situations, it can be a better alternative to a traditional loan, such as when:

• You have an emergency: If you lose your job or encounter unexpected medical expenses, a life insurance loan can be a good option. Interest rates are usually low, and you can hold off on repaying the balance until you're back on solid financial footing.
• You can't get a traditional loan: If your credit score and debt-to-income ratio make it difficult to get a traditional loan, a life insurance loan can help you get funding and reduce interest rates.

The risks of cash flow banking can be serious, particularly if you're not aware of the terms and potential implications for coverage and taxes. Consulting with a financial professional is a great way to assess your options and make a prudent plan.