4 ways to use today’s ultra-low interest rates in your wealth planning
As we navigate through this difficult time in the U.S. economy, a few bright spots emerge. One of those is the fact that interest rates, controlled by the Federal Reserve, are at all-time lows.
This trend, of course, reflects a government policy intended to stimulate the economy and allow businesses and individuals easier access to capital. In fact, government officials have indicated this policy will continue for the foreseeable future.
A near-0% interest loan policy certainly benefits big banks, which can borrow at close to 0% and lend profitably, even at low rates. It also benefits big businesses, which can expand their operations with a near 0% cost of capital. Nonetheless, ultra-low rates can also significantly benefit physicians and their families. We outline four ways you can benefit from these rates, starting with the most obvious and popular options, then moving to those that are more complex.
As mortgage rates have now reached all-time lows, many doctors who own homes have either refinanced their mortgage already or have considered doing so. The calculations involved in evaluating the long-term benefit of a refinancing are not complex and can be understood using a simple financial model. In fact, this is the type of evaluation that benefits physicians who are adept at financial modeling — a discipline we emphasized in an earlier column. For those who do not have a good handle on such modeling, several websites have mortgage comparison calculators to use, or a mortgage broker can provide this analysis.
Regardless of the resource used, the essence of the analysis is to compare an existing mortgage with a new mortgage offering a lower interest rate. A thorough knowledge of the existing loan terms (such as whether there are prepayment penalties) and potential closing costs to secure the new mortgage is essential. The goal is to calculate the breakeven point, which is the length of time at which paying the new lower-interest mortgage breaks even with the one-time additional costs of changing the mortgage. The bottom line is if the loan term is the same, and you intend to remain in the home well past the break-even point, refinancing may be a good idea.
Refinance other debt
The same concept for one’s home mortgage can be applied to loans such as practice real estate mortgages, rental property mortgages, practice lines of credit, practice equipment financing, as well as student loans.
Knowledge of existing terms and closing costs, as well as an accurate financial model, is required to make good financial decisions.
Use premium-financed life insurance
In other installments of this column, we explored the relative strengths and weaknesses of term and permanent life insurance (whole life, universal life, equity-index life, etc.). We also cover these topics in depth in our book, Wealth Planning for the Modern Physician: Residency to Retirement. The bottom line is there are significant tax, retirement and estate benefits offered by permanent life insurance.
Nonetheless, to build up large permanent policies that generate six-figure annual tax-free retirement income, physicians generally need to make significant investments into such policies for at least a few years while they work. Many would like the tax-free retirement income but are averse to paying large insurance premiums.
This is where premium financing comes in. One can finance these policies during the funding phase, only paying a few percentage points in interest, rather than the entire premium. Then, typically 10 to 15 years into the plan, when cash values have grown, the cash value can then be used to pay off the loan principal. What remains is a large debt-free permanent policy that can be used to generate tax-free income through the doctor’s retirement.
This description glosses over a complex and significant transaction with a number of risks and success factors. However, the essence of the strategy remains arbitrage, growing the policy cash values at rates generally around 5% to 7% annually, which is higher than typical premium financing interest rates.
Today, those rates have plummeted, with some banks offering rates below 3%, often with long-term lock options. As such, there has not been a better time to engage in this transaction since it became mainstream over 25 years ago.
Leverage loans for gift, estate planning
A core element of much sophisticated estate and gift tax planning is making loans between family members. Unlike loans between unrelated parties, intra-family loans must charge an IRS-specific minimum interest rate to make the loan legitimate, which is called the Applicable Federal Rate (AFR). The IRS issues the AFR monthly so taxpayers and their advisors know exactly how much interest must be charged in these scenarios. In fact, the IRS gives specific AFRs for the short-term rate (maturities of 3 years or less), medium-term rate (3 to 9 years) and long-term rate (maturities greater than 9 years). For October 2020, these rates were: 0.14%, 0.38% and 1.12%.
The specifics go beyond the scope of this article. However, one can imagine all the ways doctors could transfer wealth tax efficiently among family members, trusts, partnerships and the like when the interest rate allowed on long-term loans today is a mere 1.12%.
Often such loans provide tremendous flexibility for individuals who want wealth to transfer to younger family members (or trusts for their benefit) but want a “safety valve” back to them in case they need it. Using a loan to the individual/trust allows that flexibility. If the physician, through the years, decides they do not need a portion of the loaned assets back, they can forgive the loan using their gift/estate tax exemptions. If they want the assets back, the loan is kept in force and they get the principal and interest, per the loan terms. Either way, by making a loan today, the family has built flexibility into its plans and done so for the cost of a tiny interest rate, dictated by the IRS.
Physicians should determine how they can best utilize today’s ultra-low interest rates. For many, a few of the four tactics described here may be beneficial. When implementing any of these options, be sure to work with a trusted experienced professional advisor.
- IRS. Determination of issue price in the case of certain debt instruments issued for property. www.irs.gov/pub/irs-drop/rr-20-20.pdf. Updated October 2020. Accessed November 12, 2020.
- Wealth Planning for the Modern Physician and Wealth Management Made Simple are available free in print or ebook formats by texting HEALIO to 47177 or at www.ojmbookstore.com. Enter code HEALIO at checkout.
For more information:
Sanjeev Bhatia, MD, is an orthopedic sports medicine surgeon at Northwestern Medicine in Warrenville, Ill. He can be reached at firstname.lastname@example.org.
David B. Mandell, JD, MBA, is an attorney and founder of the wealth management firm, OJM Group, www.ojmgroup.com. You should seek professional tax and legal advice before implementing any strategy discussed herein. He can be reached at email@example.com or (877) 656-4362.