In this article we'll compare how loan interest is treated by two carriers, with a focus on SmartLock™ access strategies. Specifically, we're analyzing the difference between carriers that charge policy loan interest in advance and carriers that charge policy loan interest in arrears. It’s important that you understand the timing, mechanics, and tax implications of each carrier’s loan interest model, as loan interest is the most important factor for any client who intends to access money and maintain leverage in a cash value insurance vehicle. It’s also important to understand control and the impact of dividends or index interest crediting on long-term loan outcomes, whether the policy is treated as a MEC (modified endowment contract) or not.

Carrier A Loan Mechanics

Carrier A has great dividend growth and access to more money immediately. However, it uses a prepaid, variable loan interest model calculated through the next policy anniversary but immediately added to the loan balance upon initiation. They do allow for policy dividends earned to reduce unpaid loan principal first, followed by interest, however, this should be used as a supplement and not as a substitute for eventual repayment of the loan.

If the client repays the full loan balance early during a policy year, prorated loan interest charged for the rest of the policy year will be added back to the policy’s cash value, but this is money the client has paid and does not get refunded. Also, even if the prorated interest balance is added back to the policy, the full interest charge of the loan will be exposed to the policy’s MEC cost basis.

Carrier B Loan Mechanics

Carrier B uses a variable loan interest rate that is charged in arrears (i.e., annually at the policy anniversary). This structure allows interest to accrue over the year without immediately increasing the loan balance, providing clients with more flexibility to plan repayments or choose to pay interest out of pocket to avoid capitalization.

Carrier B also allows policy dividends to reduce loan balances: first to unpaid principal and then to interest. As with Carrier A, this should be used as a supplement. However, when combined with the ability to prepay interest and prevent interest capitalization, this can be utilized more efficiently than with a loan where interest was charged immediately.

Which carrier is better?

Why Carrier B is Better for SmartLock™ Access Strategies

For SmartLock™ access use cases, especially those involving cost basis maintenance and strategic borrowing, Carrier B offers significant advantages:

• Loan interest charged in arrears, not up front. This allows for better interest management while the loan is outstanding.

• Clients get BOTH interest control and the ability to smartly use dividends to pay down loan balance.

• Even though Carrier A may have more cash value available immediately, it is also closer to the cost basis meaning more money is exposed to the tax threshold.

• Because loan interest is not immediately charged, it does not immediately affect cost basis for MEC taxation.

• Clients can choose to repay interest before it’s added to the loan balance and exposed to cost basis.

Even in Non-MECs, Silent Transactions Can Have Consequences

Some companies promote non-MEC policies as the “safer” alternative, boasting tax-free access via FIFO (First-In, First-Out) treatment as opposed to the LIFO (Last-In, First-Out) tax treatment of a MEC. However, they fail to mention that loan interest compounds in ALL permanent life insurance, and when ignored, can quietly push any policy (even non-MECs) into taxable territory. In addition, dividends or index interest crediting used to pay down an outstanding loan also increase your cost basis exposure. This means that even in non-MEC policies, if client access is a priority, understanding the loan interest and internal repayment structure is vital to the long-term sustainability of the policy.

Here’s how neglecting loan interest and internal repayments in a non-MEC can be catastrophic:

• Client is sold on “tax-free” access and compounding growth and opens a non-MEC whole life, IUL, or other cash value insurance policy.

• Client starts to take loans out of policy and neglects the effects of loan interest compounding or internal loan repayments from the policy itself (dividends or index interest crediting).

• Loan interest and internal loan repayments silently increase policy gain exposure, with client leaving outstanding loans unpaid and/or continuing to take new loans.

• Policy eventually lapses due to loan interest pressure or is surrendered when client no longer wants to pay ongoing premiums.

• Client receives a massive tax bill because they have “accessed” more than they put in and non-MEC status does not apply when policy is no longer in force.

In a nutshell, if the non-MEC policy ever lapses due to loan interest or is surrendered because the client no longer wants to pay premiums, the client will experience one of two things: either they will not pay taxes because they have not gained anything in the policy, or they will pay taxes on gains the policy was credited for (whether or not it is money they actually accessed). Unfortunately, far too many clients experience one of these outcomes.

Why Transaction Awareness Makes SmartLock™ Planning Smarter

Truthfully, most industry professionals treat loan interest and internal loan repayments as an afterthought, but in reality, it’s the silent force that accelerates the downsides of leveraging either a MEC or non-MEC insurance policy, primarily penalizing cash flow and/or accelerating taxation. That’s why SmartLock™ strategies don’t shy away from the Modified Endowment Contract designation; they leverage it intentionally to maximize cash value flexibility, with full awareness of how these factors affects cost basis exposure. When clients borrow against their policies, where the money is going and understanding how it interacts with their ability to manage their loan is VERY important. Instead of pretending this doesn’t matter, or even worse, not knowing it matters ... we teach clients how to use this knowledge on their own terms, making SmartLock™ a proactive strategy, not a reactive oversell.

If “internal arbitrage” or “growth” is all a client is sold on when acquiring cash value insurance, they are setting themselves up to use it incorrectly. The client’s policy will never beat the insurance company that is providing it, and they can theoretically get better growth in other vehicles. What makes any cash value insurance policy powerful is the client’s ability to leverage it by automatically maintaining growth on accessed money. With SmartLock™ access strategies, we focus on helping clients gain this leverage immediately and using leveraged loans for assets that grow predictably and help them maintain their loan, leaving them in a better long-term position and truly giving every dollar two jobs.  

For more help with SmartLock™ access strategies to maximize your money, contact us today!