All You Need to Know About Premium Financing and How It Works
Are you thinking of purchasing a life insurance plan that requires a large single premium to be paid upfront? You may be offered something called premium financing.
Often positioned as a way for you to enjoy the returns from your life insurance policy while boosting your cash flow, premium financing is when you are offered a loan to pay for your insurance premiums. However, premium financing does have its risks and may not be for everyone.
Read on to find out what exactly premium financing is, how it works, the benefits and disadvantages involved, and whether this is something you should consider.
What is premium financing and how does it work?
Premium financing is a type of loan that is offered by financial institutions to help you finance your insurance policy.
It might be relevant if you are purchasing an insurance plan that comes with a large sum assured, such as annuities for retirement income or universal life plans for legacy planning purposes. Premium financing is usually offered when the premiums involved are sizable, such as when it is in the seven-figure range.
With premium financing, you can take out a loan to pay for a portion of your premiums. The remainder will then have to be paid using other means. Here’s an illustration of how premium financing might work for an annuity plan that requires a S$700,000 single premium payment.
Based on your credit score and income, the bank disburses a loan of S$500,000 and the remaining S$200,000 will have to be paid with your cash savings. The cash surrender value of your insurance policy becomes the collateral for the loan and the bank will become the main beneficiary of the policy.
In most cases, you will have to pay off the monthly interest of the loan until the policy has been surrendered or paid out. However, some financial institutions may offer you a premium financing plan that includes repayment of principal and interest, which is a better option as it reduces your outstanding principal over time.
With this principal and payment repayment option, you will be reducing your liability with the bank, which allows you to better safeguard the cash value of your policy. This option works especially well during a low interest rate environment, as a greater portion of your repayments goes into reducing the outstanding principal. However, it usually involves higher monthly repayments and is subject to the bank’s approval.
For premium financing to be a viable option, the payouts you receive from your insurance policy should be higher than what you have to repay your bank over time.
Should I consider premium financing?
Premium financing allows you to maximise the returns on your insurance policy when planned properly. However, it may not be suitable for everyone. Here are the pros and cons of premium financing and things you should consider before getting it.
Benefits of premium financing
By and large, the main benefit of premium financing is better management of your cash flow and assets.
By leveraging financing from banks, you can stay covered and protected for a larger amount. Nonetheless, how much you can borrow depends on your credit standing and existing liabilities with the bank.
Premium financing could also be useful for legacy planning, especially if you have multiple beneficiaries. Leveraging financing from the bank eliminates the need to set aside the full amount required for each and every plan.
This could be useful for High Net Worth individuals whose wealth is locked up in other fixed assets or collaterals, as it lets you provide immediate liquidity for your beneficiaries in times of emergencies.
Disadvantages of premium financing
Despite its merits, premium financing has its downsides, which include and are not limited to:
- Interest rates are not fixed
Premium financing uses a variable interest rate that will fluctuate along with market conditions. When the rates go up, you’ll have to pay more in monthly interest payments. However, the income from your policy remains unchanged, thus resulting in a net decrease in your monthly income.
- Weakened Total Debt Servicing Ratio (TDSR)
In Singapore, your total monthly debt obligations – whether it’s a combination of your housing loan, car loan or personal loan – must be less than 55% of your gross monthly income. This is known as TDSR, and financial institutions rely on this to determine your eligibility for a loan.
When you take up premium financing, you will be holding on to the loan for as long as the policy is in force, and potentially for life. This weakens your TDSR and impacts your ability to apply for additional loans in the future.
- Lack of liquidity
A premium financing loan is a long-term commitment as most policies require a period of time before its surrender value reaches 100%. This usually takes years and decades.
You should hold on to your policy until it reaches the breakeven point at minimum, or risk making a loss if you surrender your plan prematurely. Doing otherwise may mean having to pay out of pocket, or risk having your personal assets seized, if the cash value of your policy does not cover the loan amount sufficiently.
- Deficit in earnings
Depending on the terms of your plan, you may not be receiving payouts in the first few years of your policy but monthly interest payments still have to be paid. This could result in a cash flow deficit.
Consider if these additional expenses during the first few years of the policy term are manageable before taking up a premium financing loan.
- Risk of losing your policy earnings
As premium financing is offered by the bank, there may be instances where the bank may recall the loan partially or fully due to poor conduct of your overall loan obligation. This includes instances such as failing to keep up with monthly repayments, or having outstanding payments in arrears. It could also be due to your TDSR being breached, where the bank may then have to reduce the loan given to you accordingly.
If you are unable to finance your loan, the bank retains the right to cash the policy and claim what is owed before returning the excess to you. How much you may get back depends on the value of the policy at the time of surrender. You may not receive anything if your policy is in its early years. You will also lose your insurance coverage when your plan is surrendered.
In addition, the bank may use the cash value from the surrendered policy to clear off any other existing liabilities you may have with them. This further reduces the amount that you may potentially get back and there is a risk that you and your dependents may not receive anything.
As you can see, there are risks and disadvantages associated with premium financing and you should consider carefully if the benefits outweigh these before choosing it as a strategy.
Other things to consider before getting premium financing
Are you ready for a premium financing loan? These are some questions you should ask yourself before adopting premium financing as a strategy.
- Do you have sufficient emergency funds?
You should have sufficient emergency funds and protection plans in place to help you with your expenses and emergencies while servicing your premium financing loan. To avoid having to surrender your policy, you should also have enough reserves to repay the bank if a partial or full repayment is required earlier than expected.
- Are you planning to take on more debt in the future?
Premium financing increases your TDSR and affects your ability to take out additional loans. As long as there’s a chance that you might take a loan in future, whether it is a second home loan or personal loan, premium financing may not be the best idea.
- Can you accept the risks of fluctuating interest rates?
Interest rates will change and an increase in rates could potentially reduce or negate the earnings from your policy. Make sure this is a risk you are prepared for and ensure that you have sufficient financial reserves to ride out such waves.
Is premium financing suitable for me?
Because of the large amounts involved, premium financing is typically geared towards high-net-worth individuals, entrepreneurs and business owners who are looking to free up their cash flow when purchasing a high premium insurance policy.
It also makes sense if the intention is to keep the money that would have been spent on the policy, in instruments that provide a greater return on investment. Premium financing is also a viable option if you’re not willing to liquidate your assets to pay for the plan.
Having said that, because of its complexity and risks, premium financing is not for everyone. If you choose to adopt this strategy, you should have enough financial reserves such as assets that can be liquidated under financially challenging circumstances. If you don’t, the outcome could very well be bankruptcy.
You should also consider how this impacts you and your loved ones if you lose your insurance coverage as a result of not being able to repay the premium financing loan.
For these reasons, consider premium financing very carefully. Think hard about whether you can commit to it for a good number of years before adopting it, or you may end up losing more than expected.
Need help? Speak to your bank’s Relationship Manager to find out if premium financing is suitable for you, and if not, what are the alternative ways to help you meet your financial goals.