Why I Disagree with Dave Ramsey’s Insurance Advice (Part 2)

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After writing Part 1 of “Why I Disagree…”, I got a call from the 32-year old dad with the infant daughter, addressed in Part 1. Here is why he would have been better off skipping life insurance when single.

This young couple have been renting for $900/month and want to buy a modest house for $130k.  Buying a house is part of raising a family.

Here’s the financing package:

House costs $130k.  He needs to only put down 3% as a first-time homebuyer.  $126k mortgage @ 4.25% for 30 yrs is $620/mo (principal and interest), $162/month property tax, $48/month PMI (private mortgage insurance), $100/month for property insurance, totals $930/month, what they’re paying in rent.

I suggested a 15-year mortgage for a lower interest rate, save on PMI, saves a ton of interest, and doubles as an education saving plan for their baby girl who will be going to college about then. This will be a huge help in their future.

Here’s what a 15-year mortgage looks like:

$126k mortgage @ 3.875% for 15 yrs is $924/mo (principal and interest), $162/month property tax, $36/month PMI, $100/month for property insurance, is $1222/month, about $292/month more than the 30-year mortgage costs.

The 15-year mortgage is the better path, but the payment is higher and being able to swing it often hinges on how you’ve prepared.

15-year mortgage vs 30-year:

principal interest payment PMI Total savings Total lifetime P&I payments
30 yr @ 4.25% 174 446 620 $48/mo $223,000
15 yr @ 3.875% 518 406 924 $36/mo $166,000
  $40/mo $12/mo $52/mo   $57,000

What difference does it make?

Notice they pay down mortgage principal by three times as much with the 15-year plan, because the payment is higher and interest rate lower.  Also, not only is PMI less, but it can be dropped sooner when equity is at least 20% of house’s value.  They’ll save $57,000 of interest, half the price of the house!

They’ll pay it off two years before their daughter goes to college, can sock away $10k/yr for those two years and have $924/mo freed up for college tuition and a wedding, while the 30-year mortgage holder plods on with none of these funds.

How does this relate to Dave’s life insurance advice to singles: “The younger you are, the more affordable term life insurance is, so there’s no reason to wait until you have a family to get insured”?

One’s ability to avail themselves of the superior 15-year plan hinges on whether they are still paying on school debt and/or the size of their down payment.  The $300/month difference may be the college loan they are still paying … or aren’t.

Not only did buying life insurance when younger not save premiums, but it’s those sorts of decisions that undermine one’s ability to take the 15-year path.  Those premiums should have gone to school debt or a house down payment, rather than life insurance when single and without dependents.

Why I Disagree with Dave Ramsey’s Insurance Advice (Part 1)

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More than once someone has come to me, about to make a life insurance mistake because “Dave Ramsey said…”.

I admire Dave as he has done a ton of good; but regarding insurance, I have to take issue.

Here is one of Dave’s insurance commentaries which I think miss the mark.

One recent article was entitled “8 types of Insurance You Can’t Go Without”: auto, homeowner/renters, umbrella, health, long-term disability, term life, long-term care, and identity theft.  A young person with school loans and/or credit card debt needs to keep overhead low, so I hate to saddle anyone with all those premiums.  Because most people pay more into insurance than they get out of it, Larry Burkett used to say, “The cheapest form of insurance is self-insurance”, and “Don’t insure that which you can afford to pay for yourself.”  Dave promotes insurance liberally; Larry did sparingly.  I agree with Larry.

There is a very real danger to consumers to waste money on premium dollars that could be employed paying off debt and saving for future needs.  Debt free trumps well insured any day.

Dave: “You need 10–12 times your yearly income in term life insurance.  That way your income will be replaced if something happens to you.”

Mike: For those who need it most (folks with young children), Social Security Survivorship benefits are substantial. First get a good handle on how you are insured already.  Remember most pay on a term policy 20 years and throw it in the trashcan.  Using multiple-of-salary to determine amount of life insurance leads to overbuying.  Thinking through this first step more carefully saves even more than shopping for the best rate.

Dave: “What about singles with no dependents? …If you’re debt-free and have enough cash to pay for your burial, you can hold off on life insurance, but why would you? The younger you are, the more affordable term life insurance is, so there’s no reason to wait until you have a family to get insured.” [This sounds like a classic sales line.]

Mike: I recently worked with a 32-year-old new dad who had bought a 20-year level term policy eight years ago when single. Now he has an infant daughter with only 12 years left on his policy.  What he bought is not enough, he’s having to start over, so it didn’t save money but wasted it.  He should have used those premiums to pay off student loans, save for a house, or fund a Roth.  Wait till you need insurance to buy insurance.

Dave: “Whole life insurance is a rip-off!  It often costs hundreds of dollars more a month and includes a “savings” plan with a terrible return.”

Mike: I never recommend whole life, but when someone has an old cash value policy with one of the better companies, the rate of return on cash values may be quite good (4% tax-free).  Know what the cash value rate of return is before you drop it.  If favorable, consider turning it into a reduced paid-up policy and using that it as your emergency fund.  Don’t throw the baby out with the bath water.

Dave Ramsey has helped so many, but don’t blindly follow his insurance advice.  Get a second opinion.

 

Worst Case in a Long Time Why Consumers Need Impartial Advice

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I recently got a call from a mom and adult daughter, neither married, who had had equity no-load mutual funds within IRA’s.  They got spooked during the volatile first quarter of 2016, heard a fellow on the radio promoting a strategy “safe from the stock market”, and jumped out of the frying pan into the fire.

Commission-driven Recommendations:

Asserting he wants to do what’s best for the client, this financial “expert” encouraged Mom, age 70, to roll her IRA to an Athene annuity to fund an IRA, which some liken to wearing a raincoat indoors.  A tax shelter within a tax shelter is redundant and carries unnecessary fees. It’s an equity indexed annuity guaranteed to not lose in stock market decline and participate in the market up to 3% per year.  If the S&P goes up 10%, she gets 3%, and if it goes down 10% she loses nothing. There are better ways to address risk, but it is emotionally appealing.

The commission creates enormous surrender fees, 10% declining by 1% per year over 10 years. She avoids possible stock market loss but pays sure transaction costs while limiting growth dramatically.  The agent argues that the surrender fees vanish if she keeps it long enough (true), but all that while she is missing equity opportunity which has also historically been surer when one commits to the market for 10 years (the time it takes to avoid annuity surrender penalties).

His recommendations were worse for the 40-year old daughter: a $450k Minnesota Mutual Flexible Premium Universal Life Insurance plan for which she pays $50/month and has made two additional $11,000 payments and is scheduled to make two more.  It has some long-term care benefits which confuses comparison.

The daughter has no kids, makes less than 25k/yr, and lives with her mom who is 30 years older– hardly a case that warrants that size policy.  Daughter can’t afford (out of her salary) those premiums anyway.

Understanding what you have:

Rarely do consumers comprehend the inner workings of such a policy, so we conference-called Minnesota Mutual to find she’s charged $152/mo within the policy.  The cost above her $50/mo payment is coming from her surrender value (which came from the two $11,000 payments).  So she’s got an $1800/yr subtraction to what’s (already) inferior investment growth within the policy.

Minnesota Mutual sales literature says this:

The primary purpose of life insurance is to give you a means of support after the death of a provider…

Another aspect of permanent life insurance is that it can grow cash value …

Minnesota Mutual publishes proper advice, but the agent promotes it improperly, and consumers listen better to a persuasive agent than they read a sales brochure.

The agent does not recommend what’s usually appropriate, a Roth IRA.  But that’s not the worst of it.

Using life insurance policy as an investment is rarely a good idea.  Aside from that, how will she come up with two more 11k annual payments making 25k per year?  By tapping assets… but all she has is her IRA.  The agent had her make an early IRA withdrawal two years!  The client didn’t know it was taxable until she got a bill from the IRS for $3267: $1687 for federal tax @ 15%, $1125 early withdrawal penalty @ 10%, $118 of interest, and a $337 “substantial tax understatement penalty”.  I asked the agent how she’s supposed to pay that, to which he replied, “a policy loan” (from the policy she did not need).

At this point she has paid $50/mo for 28 months or $1400 + two payments totalling $22,550 equals $23,950 lifetime premiums.  The $152/month charges and surrender penalties reduced her cash surrender value to $9,946 less the $3267 due the IRS, nets a 70% loss from this “investment” designed to protect against stock market loss.  The Subprime Mortgage crisis wasn’t that bad.  The agent defends it saying if she keeps it for decades she can avoid surrender fees. However, considering the $1800/yr internal costs and missed earnings opportunity, that’s smoke and mirrors.

Noncommission-driven recommendations:

Here’s the new plan: The daughter is getting a $100k 10-year level term policy for about $150/yr.  (I do not get a commission.)  She and her mom have $8k of credit card debts, some as high as 8% and 14% which they’ll pay off with the cash value, then focus on their house mortgage @ 4.25%, to be debt free in 18 months.  A dollar saved is a dollar earned, and those tax-free earnings also avoid stock market risk.  Then they will dollar cost average into Roths, what they should have been doing all along.

After reviewing this with the agent, he paid the daughter $3000, about what she owed the IRS. This was a gesture of good faith, but nowhere near what she would have saved with objective advice upfront to avoid the mess altogether.

 

Collecting Multiple Life Insurance Policies Leads to Redundancy and Waste

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Do you own several life insurance policies? People tend to buy policies piecemeal in response to life events like the birth of a child or an agent’s sales pitch. Collecting life insurance policies is often uncoordinated and inefficient. Just having multiple policies, each with an annual policy fee, and missing volume discounts of larger policies is costly. How do I know if I have too much life insurance and am wasting resources?

Most consumers think this way:
• My agent recommended it; it seems reasonable.
• We are expecting our first child! It seems time to buy.

A proactive consumer thinks this way:
• I’ll get objective opinion from someone who does not sell policies.
• I’ll engage someone familiar with the entire insurance market, rather than primarily representing one company.
• I won’t allow my worst recallable memory to become my baseline (e.g. an uncle who died young), but I’ll think in terms of probabilities.
• I’ll consider the opportunity cost of premiums if invested elsewhere.

Case Studies: The Pastor and the Doctor

I just finished two cases, one for a 65-year-old doctor with no dependent children and the other for a 32-year-old pastor expecting their first child. Despite having good companies (USAA, State Farm, and Northwestern Mutual), they both improved a lot. Insurance consumers can profit from a gatekeeper. Instead, most rock along leaking significant resources month after month, year after year, unaware of how much they could save.

The young pastor had a $100,000 20-year level premium State Farm policy that was 8 years old (12 years left of level premiums) costing $24/month (not a good buy), a 100k term life policy provided by his church, and had just been sold a $750k Northwestern term policy.

I directed him to socialsecurity.gov/myaccount to see what survivorship benefits his child and wife would get at his death: about $2400/month. He was ignorant of this, which is a shame that something so relevant to an insurance purchaser is rarely addressed by an agent. Social security survivorship benefits for him are essentially equivalent to a $500,000 term policy.

He replaced the State Farm’s 100k and NML’s 750k term, with a 500k personal policy. 500k with the 100k through work buys a nice house near family, a 100k education fund, and a 100k emergency fund. With no mortgage and liberal savings to replace a car, etc., Social Security will pay the bills. She’s a teacher who could work once their child is school age.

We talked about the low probability of death within 20 years, which makes for better choices than a fear-inducing (What if…?) sale’s pitch. This improbability translates into a high probability of “wasting” those premiums. We considered the opportunity cost compared to putting more of it into a Roth or accelerating the mortgage. The insurance amount respects the wife’s emotional temperament.

The Northwestern term cost $407 first year, growing to $1200/yr by the 20th year. The new policy costs $316/yr guaranteed level for 20 years. He dropped the State Farm and Northwestern, the doctor dropped the USAA, big name companies that are strong in property and casualty and cash value policies, but not term insurance.

The Potential Savings

This 32-year old initially saves $32/month, which may not seem like much. However, in a Roth using a Sector strategy, it could grow to $25,000 by their baby’s first college year, or over $1 million in 50 years, his normal life expectancy. Rather than buying excessive insurance paying only in the unlikely event of death within 20 years, savings are redirected towards life events that normally occur.

The doctor had collected a hodge-podge of life policies over his career. We started with an income goal for his wife and saw he was over insured. I evaluated each policy (NML and USAA cash value and AMA term), and he began dropping the poorest and keeping the best. This will save $400/month from the first three, plus more from the one Northwestern he kept but modified. His health is good.

I guarantee clients save my fee back within 18 months, a 60+% return. This doctor saves it back in less than three months. Please see Testimonials. I’ll give an initial interview free. Call me at 706-722-5665, or email to talk about your situation.

Making a 10% Rate of Return by Paying Premiums Annually

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Many people pay monthly, quarterly, or semi-annually for things they could pay annually.  Consider an insurance policy costing $1000 annually or $87.50 monthly.  How much does it cost to pay it monthly?  In absolute dollars, it’s an easy calculation: twelve $87.50 payments total $1,050 or $50 of annual interest.  But if I have at least $1,000 in savings, the question becomes, “Should I tap savings to pay annually and save $50, or should I leave savings undisturbed to earn interest?”  What does the $50 savings translate into as an interest rate and how does that compare to the rate of return I’m earning on savings?

At first blush one might think paying monthly costs about 5%, since $50 divided by $1000 equals 5%.  However, the outstanding balance to the insurer reduces each month.  Initially it’s $1000, but by year end it’s only $0.  So, the average outstanding balance for the year is around $500, making $50 closer to 10%.  Paying annually effectively saves about 10% on the money you must withdraw from savings to pay annually.

A financial calculator reveals the exact annualized interest cost for this example to be 10.8 %.  But it gets better!  Because interest must be paid with after-tax dollars, saving it is like earning 10.8% tax-free; whereas a 2% money market return, after federal and state income taxes, nets less.  I can effectively multiply my yield five times!  The bottom line is if I have enough in savings to pay annually, I’ll gain a lot more saving finance charges than earning a low taxable interest rate.

If you don’t have a financial calculator and want to know how this relates to your situation, do like we did in the above example: Multiply the monthly payment by 12 to see how much extra you pay vs paying annually ($50); divide this by the annual payment ($1000); double the resulting 5% to 10%.  This will give you a percentage factor.

I wrote this article years ago when one could earn 5% on money market accounts, to show that saving 10% finance charges was a better use of savings.  Since then money market rates have declined, while finance factors with many insurers stayed the same, making the advantage even greater.

For insurance policies, typically you can change to an annual payment mode even if you’re not at the policy anniversary.  Simply ask the company how much is needed to pay to the anniversary.

If you pay annually and decide to drop a policy midyear, typically insurers will refund unearned premium.  You can confirm this when changing to annual mode.

Remember that we are addressing a fine-tuning process for after you’ve addressed more consequential issues such as these:

  • Do I even need this product or service?
  • Is this the best buy, the right type of coverage, the right duration, etc.

There is also a behavioral dimension that can trump saving finance charges.  The discipline of systematic monthly withdrawals from checking is huge.  If you take the annual payment from savings, it’s important to make monthly payments back into savings.  If you spend even one of these, you will more than unravel the interest advantage you have realized.  Automation beats procrastination!

Saving $50 of interest on an insurance policy may not seem significant, but over many years adds up.  Financially successful people often think in terms of percentages, not just absolute dollars.  Moving savings from earning a taxable 2% to saving an after-tax 10% is a dramatically better use of dollars.