Paul Winkler: Welcome. This is “The Investor Coaching Show.”
Okay. So there was a topic of conversation that you brought up to me the other day, and I thought we would just cover it because it was good. It was a video.
Jonathan Walker: Yes.
PW: And it talked about velocity of money, as I recall. Right?
JW: I believe that’s correct, talking about how you take money from: “Here, do this, do that.” And it’s all done through certain investment products.
Velocity of Money
PW: Okay. So, velocity of money from an economics perspective. So for those of you that don’t know what it is, the idea behind it is, you have, and I always draw a box. And I say, “Okay, I’ve got this rectangle I draw.” And I say, “You put $100,000 in your local friendly bank, and then they take $10,000 of it, and stick it off to the side as a reserve requirement.
So that if anything happens where you need to have some money out, well, you’ve got access to some of it, because they’re assuming you’re not going to pull all of it out at once. And there are enough people that are deposited in a bank.”
It’s like the scene from “It’s A Wonderful Life” where George Bailey says, “Hey, your money’s not in this bank. It’s over in Joe’s house. And it’s over in Charlie’s house. And it’s over there. You remember what it was like living in that slum?”
The velocity of money has to do with how the same money can flow in and out of the economy in a given period of time.
And he’s talking about the reserve requirement that money goes into the vaults. So you take that and you put $100,000 dollars in the bank, so then $10,000 stays in the bank and $90,000 gets lent back out to somebody else who needs to borrow money.
Then that money flows to the economic system. And let’s say it becomes $70,000 because some of it is spent from various things, but some of it ends up back in the system again. So $70,000, somebody makes a deposit, and then $7,000 is held as a reserve requirement. $63,000 is lent back out. It turns into $50,000 down the line.
And then of that $50,000, it gets put back into the bank and then $5,000 is held for reserves. And the other $45,000 went back out. And money will actually be used six, seven, eight times, something like that. That’s the idea of velocity of money.
It’s a concept that some people use and go, “Wow, this is really cool. I wonder if I can become my own bank and do this, because banks have big buildings. They do pretty well. Maybe I can be my own bank. How can I do this?”
Trending Life Insurance Policies
JW: Well, this came up from a buddy of mine. He keeps seeing these things on Instagram or TikTok or whatever where basically you can buy these life insurance policies. You can take a loan against it, and you never owe the money back.
It’s a get-rich-quick scheme. He’s like, “How are these things working?” He’s like, “What’s the catch?”
If you have to ask what the catch is, you probably don’t want to get involved in whatever it is.
PW: And he said this guy in the video, which blew my mind, he says, “I can go and lend myself money. And then my business can repay the loan.” And I’m doing this from memory.
JW: Yeah. I may need to pull it up. Let me, while you’re chatting, I’ll pull it up real quick.
PW: It was something like that. It was like I repay myself, and it’s okay. So I have a life insurance policy, and it builds up cash value. Basically the way it works is when you buy life insurance, and I like describing what is called the unbundled approach to life insurance, because it’s easier to understand.
You have unbundled. You have bundled. Bundled what might be a whole life policy. Unbundled might be universal life, and they call it unbundled because you see all of the things going on in life insurance policy.
You see the cost of insurance. You see the savings account so to speak or the investment account, and then you see the interest rate being paid. And you can put together the working parts. Well, if you have, let’s say a $100,000 policy, let’s say that the cost of life insurance is $20 because you’re young.
So you put in $200 in premium. So $20 of that $200 goes toward your life insurance costs, and then the other $180 goes into a savings account. And the idea being that that savings account is going to earn interest on your behalf. Well, as time goes on, you get older, and that cost of insurance will go up.
The idea being, and this is what they try to sell you on, is that you’ll build up a bunch of cash in your policy such that at some point in the future, you can make a loan against it. You’re basically borrowing against the death benefit.
Get the Whole Picture
So you’re actually getting an advance on the death benefit, and they say you can borrow against it. And then what you can do is your company can borrow the money and you charge your company interest, and your company pays interest and deducts the interest payment. And it sounds very sophisticated.
JW: And that’s the thing. I mean, I think what most, and kind of like my buddy, he’s not. I don’t mean any of this negative at all, but he’s not what would be deemed a sophisticated investor.
PW: Well, most people, even those that think they are sophisticated, aren’t anyway.
JW: And they’re getting caught up in this.
You want to have the whole picture in mind before getting caught up in something.
That’d be great, but they’re seeing these things. And he’s a younger guy, and right now the other thing that kind of piqued his interest was the rental real estate aspect of it.
This guy in the video talks about pulling money out of a life insurance policy and taking that money and loaning it to his company and then doing a hard money loan and buying a piece of real estate.
I told him, I was like, “Look, you don’t understand. These guys are doing this professionally. And it’s extremely, extremely risky.” And I said, “If one of these things doesn’t click, he’s going to be in some really hot water.”
PW: He’ll be bankrupt.
JW: And so I said, “This is not something that, quite frankly,” and I even told him, I said, “As a financial planner working at a financial planning firm, we can’t advertise stuff like this.” I said, “There’s a reason why we can’t do that kind of stuff. We’d get in a lot of trouble.”
PW: Because it is far riskier than meets the eye.
JW: Absolutely.
PW: And when you have a fiduciary responsibility, in other words, what you say has to be in somebody’s best interest. You can get in some serious hot water for telling people to go do these things.
JW: Yeah. I mean it gets really complicated really fast. There’s a lot of moving parts and pieces. The first rule of investing should be you don’t invest in anything you don’t understand or can’t regurgitate. Basically I said, “Watch the video as many times as you can. How many times is it going to take you to where you think you might understand it?”
A Breakdown of What’s Actually Going On
PW: Right. And what the guy’s saying was, and you sent it to me, and I watched it. And I was like, wow, that’s super misleading. So I’m going to put it to you guys in a different way than you might be thinking about. Okay. So he said you can go and charge interest.
Ask yourself this question: Do you think you can get away with it?
If you went and built up a big savings account and said, “Okay, I’m going to loan my company money,” what do you think would actually happen next?
Or, let’s say you won’t get away with it. Let’s just ask if it even makes sense to do this.
So I loan my company money, and my company pays interest on the loan that I have made to my company. That’s my company. So they deduct the cost of the loan. Okay. So they deduct the cost of the loan. This all sounds great.
Well, guess what? You lent the company money. Who pays the taxes on the loan revenue or the interest revenue on that loan? You do. So you on the one hand deducted something and on the other hand had to declare it as income.
Does this even make sense? I mean, then they’re not telling you that part of it in the video, which was mind boggling to me that this guy is doing that. Back many, many, many, many moons ago, there was this idea that you could actually borrow from a life insurance policy, and then you could actually deduct the interest payment.
This is a concept that actually made sense, but it was at least 30 years ago that it made sense. The loophole has been closed since then, let me just put it that way.
But there used to be a loophole regarding this, and it did make sense. Why they’re carrying it forward and acting like it still exists, I don’t know.
Borrowing Money Off of a Life Insurance Policy
Here’s the idea behind borrowing off of a life insurance policy. You’re getting an advance on the death benefit.
Say you go and put money into a life insurance policy. You pay that little term insurance cost or the insurance cost, and the other money that went into a savings account is there still.
Let’s say you had a $100,000 policy just to keep this nice and simple. You built up $20,000 of cash value, and you have an option B death benefit, or an option 2 death benefit.
What happens now is that your death benefit equals $120,000. Well, remember what you’re paying for when you pay that premium. You’re paying for life insurance.
You’re paying for $100,000 worth of life insurance. As you get older, the cost of insurance goes up. So that $200 premium you paid at first, you were only paying $20 for the life insurance.
Borrowing from an insurance policy is essentially an advancement on the death benefit.
Then you start paying $40 and $50 and $60. So it’s a much smaller amount going toward that cash value as time goes on.
But they say, “Hey, you can borrow against your policy.” What does that mean?
You can borrow against that cash, and remember your death benefit. My example was $120,000. You can borrow, let’s say $10,000. Well, now if you die, your death benefit is $110,000, because you have reduced your death benefit by $10,000.
Now what do they do? They charge you interest on that loan. Oh, well, wait a minute. What do I have to pay interest for? Because you’re advancing on the death benefit.
Well, why would I do that? Because it gets you out of paying taxes on it if you’ve pulled out taxable gain on the policy. Fat chance that you’ve pulled out taxable gain though. Why, Jonathan? Why is it a fat chance?
JW: Well, here’s the thing to kind of back up a little bit at that point. Most people don’t even realize someone has to pay it back. I’ve had it said to me too that I can take the loan off the policy, and it doesn’t cost me anything.
Not only that, but I don’t have to pay it back. Well, somebody will be paying that back.
PW: It’s either paid back by you or the death benefit.
How Likely Is Loss or Gain?
JW: That’s exactly right. And they don’t see it. Now what they’re telling you and what I told to my buddy, I said, “Look, you have to realize that the insurance company is not tailoring this policy for your benefit.”
PW: They’re not stupid.
JW: No. And I said, “They’re assuming the risk. So they’re not going to tailor the benefit to you.” That’s just Insurance 101. Right?
That’s not anything bad or whatever. That’s just the nature of assuming risk. Look past what sounds good to what’s really going on.
PW: So I’ll keep this simple. The reason I said that there’s no gain, the likelihood of gain is because you have to add up all the premiums that you’ve ever paid.
Those premiums have to be exceeded by the cash value by a pretty significant amount, or it’s got to be exceeded for there to be a taxable gain. So you got premiums paid.
Let’s say you’ve paid $15,000 in premiums, and now your cash value is $20,000. So you’ve got a $5,000 gain. It’s only that $5,000 that’s not subject to taxes. The other isn’t subject to taxes either. But it’s the only thing that you’re getting back that would have been subjected to taxes otherwise.
You’re paying interest on borrowing that money. Now they credit money back as if the money were still there, so you can have a low cost loan. But it’s a loan still, and they’re still charging you interest.
Now, you’re crediting it back, so it’s not very much.
But it’s not like you’re getting away with something.
And if that cost of insurance becomes high enough, remember you’re still paying on $100,000 worth of life insurance.
And the cost of insurance keeps going up as you get older. If all of a sudden you’ve borrowed that money out and there’s no cash there and your premiums aren’t enough to cover that cost of life insurance. This is complicated.
But if that happens, then you have a lapse of the policy. The policy goes out of force. When that policy is no longer in force, there is no death benefit, right?
That loan was an advance on the death benefit. If there’s no death benefit then there’s no advance on the death benefit. If there’s no death benefit to borrow, there’s no money there.
Survival Mentality Can Lead to Mistakes
Guess what? You got a taxable gain that’s taxed. That $5,000 in gain or whatever it is at that point is now taxable income. Like Jonathan said, it just blew up.
JW: Yeah. I think we all have on some level, even this is an ethical statement, we have a natural God-given survival mentality to try to get ahead.
PW: I want to beat the man.
JW: Beat the man. That’s exactly right. And I think this is where this is rooted. I mean.
PW: I think it is.
JW: And you have to think about it. If the insurance company knows this is going on and they know that they’re on the losing end of this, they hold the policy. You don’t think they’re not going to do something to change that?
Those trying to sell you on the next greatest way to make some quick cash at no risk to you aren’t turning a blind eye to the situation.
I mean that to me is the whole root of this. It’s not like they’re turning a blind eye or anything of that nature. They know this is going on.
PW: Yeah. Well, it’s not only that. It’s the government too.
JW: Absolutely.
PW: Because we think that we’re getting one over on the government.
JW: We’re not.
PW: And like I said, that loophole was closed.
JW: Years ago.
PW: A couple decades ago.
JW: Absolutely.
PW: I learned this early on, because that’s where I started. I started out in the insurance business, and we had every scheme under the sun to try to get people to buy permanent life insurance, because the commissions were so high.
So what happens is a couple of loopholes are found and then the government goes right ahead and closes them.
JW: Well, you got to look at the commission side of it. I mean, they’re more than happy to let you borrow the money from the whole life policy at 5% or 6% when they’re making 8% or 9% on the money. I mean, it’s a math situation.
PW: So they’re not losing anything, and you’re not gaining anything by it. It’s not like you’ve found something to beat the man or anything like that so to speak. So that’s one aspect of it.
Demand Is Unreliable
Now, the other aspect of it, as he said, is the velocity of money. I’ve heard, I can’t tell you how many financial gurus I’ve known that got stung on real estate when it went the other direction on them.
All of a sudden, the real estate that couldn’t ever go down in value, has an interest rate increase, or you have a company move out of town. And they employ a lot of people, and then the number of people that need rental property, or people move from renting property to owning it.
You simply cannot predict which way demand will go, so it doesn’t necessarily do any good to follow demand with everything you’ve got.
They don’t want to rent it anymore. They want to start owning it. And then all of a sudden the demand for rental units starts to dry up to some extent. Or interest rates go up, and then all of a sudden you start to squeeze out the ability for people to afford rents.
Then what happens is then units start to go unrented, and then you have to drop the rental rates in order to get people back into them. Or the number of units in a town starts to go up, because they build more and more and more units.
And then when they start to build them, because someone sees that there’s a lot of money to be made there. So people start to build more units. Then all of a sudden, there is more supply than there is demand.
JW: Absolutely. I recently just went through that with COVID. I mean, you can probably think of several friends. I mean, I’ve got several family members who were working for corporations that once COVID hit, they transitioned everyone to work from home.
They’re still at home, and those companies are either still supporting those brick and mortar locations even though there’s nobody there, because there’s not another corporation that wants to take over that piece of property.
PW: Right. So now you’re sitting on commercial property that is empty, and I’ve seen a bunch of it around.
The Nature of Trends Is to Change Unpredictably
JW: Yeah. I mean, you probably, I mean, I know several. I’m sure you know several people too that have run into that situation.
PW: Well, and it’s cyclical. It’s interesting, because, Jonathan, over the years I’ve seen so many different things come and go. I remember when I first moved to this town; the hot thing was condos.
That was the hottest thing going. And then that became kind of the fad that went by the wayside, and you couldn’t give them away anymore.
Then you saw mall properties, that became a big deal, and then that kind of went by the wayside. I’ve seen various trends in real estate change.
You don’t really know when they’re going to change. So that tends to be one of those things that can be super, super risky as well.
But like you said, things move against you. And then all of a sudden you’re sunk. You’re stuck with something, and then the whole house of cards comes crumbling down.
Velocity of money sounded like a great idea. But what velocity of money actually ended up becoming is the speed at which your money actually moved away from you.
JW: Every idea sounds like a great idea until it isn’t a great idea. And the question is when is that going to be the case? I mean, I look at some of the one banking institutions in particular that I worked for.
Every idea sounds like a great idea until it isn’t a great idea.
The big deal was being downtown. It was, “Hey, we need an office downtown.” And I mean, granted, they had the means to make it happen. But at the same point in time, they didn’t buy a building. They rented a building. So they bought their rights to the building. But within a couple of years, that was out. And we were not there anymore.
PW: Well, and that’s interesting. It’s a sophisticated bank, and they called it wrong.
And that’s just it, and these people play off of that. Being an insurance agent, it drove me crazy when I would hear people tell the public not to buy whole life insurance.
I would get so mad, because my life, my livelihood, was based on selling whole life insurance. I didn’t want you to tell the public that what I was selling people wasn’t any good.
Don’t Buy Something You Don’t Need
JW: I mean, I will say, and I think you would agree that on some level, the inception of certain policies or whatever, I think they started off with the right thing in mind. Whole life insurance probably started off with the right thing in mind, but over time that has morphed and changed and become something that it wasn’t intended to.
Often investment ideas and strategies begin with right ideas and goals in mind, but they devolve and morph into things they weren’t intended to be.
And that’s the issue that we run into today is that most people get sold stuff that they don’t need.
PW: Well, where did it come from? And that would probably be an interesting topic of conversation, that concept of permanent insurance and whole life insurance. A lot of it, I think, came out of some history that we probably ought to share with you.
Because some of the history, if you want to get into investing markets and stock markets and how certain things came to be or how they came to be in popularity, you probably have to walk through history. So I think we ought to talk a little bit about that.
JW: Sure.
PW: That’d be kind of fun. So you’re listening to “The Investor Coaching Show.” Paul Winkler along with Jonathan Walker.
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