Should You Borrow From Your Life Insurance Policy?

Is it a good or bad idea?

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Traditional life insurance was designed to provide beneficiary death benefits in the event of the insured person's death. However, there are now some life insurance products available that include a savings or investment component.

Some insurance agents tout the benefits of life insurance with investment components. Those benefits include being able to borrow money from the cash value of the policy after you've paid premiums. Two types of life insurance policies that provide cash value are whole life insurance and universal life insurance. Check your life insurance policy to see whether it includes a loan provision.

Being able to use your policy if you need an emergency loan sounds great. But be aware of the pros and cons of policy loans to ensure that you don't put your coverage and paid premiums at risk.

Can You Borrow Money From Term Life Policies?

Most of the time, you can take cash from your life insurance policy after you have built up the cash value. You will have to contact your financial advisor or insurance agent to determine your policy's cash value. Discuss what the impact will be on your policy, as well as any tax implications.

Inexpensive life insurance policies, such as term life insurance, don't build any cash value. For that reason, they don't allow you to borrow money from them. Term life insurance is so affordable because it is purely a life insurance policy.

Term life has no value other than the actual death benefit paid upon the death of the insured. And that's only if the insured dies within the fixed term.

Note

If you have the option of borrowing from your life insurance policy, you probably own a policy that offers cash value.

Should You Borrow From Your Policy?

Before you move forward on a policy loan, talk with your financial planner to understand the long-term and short-term consequences and risks. There are many hidden costs you may not be aware of, so you want to be sure this is truly the best option for you. 

Ask your agent or advisor to run an "in-force illustration," which will show you how taking a loan would impact your policy. Weigh the pros and cons, and also explore other options. Keep these topics in mind:

  1. Find out how the loan and interest would impact your policy. Ensure that the death benefit portion is not at risk.
  2. Learn whether you will have to pay an "opportunity cost."
  3. Make sure you can afford to pay the loan interest and other fees. Interest costs could be compounded, meaning you could be paying interest on your interest.
  4. If you aren't able to pay back the interest on your loan, think twice.
  5. If you rely on the policy's dividends to pay the loan interest, take a close look at the details with your planner. If you borrow from the policy's cash value, it reduces the amount of available collateral for the loan. It also reduces dividends and generates less money to cover interest payments. This can be costly, and it could even cause you to lose your policy.

How Borrowing From a Life Insurance Policy Works

One big difference between policy loans and traditional loans is that you don't have to pay back the loan to your insurance policy. When you borrow based on your life insurance policy's cash value, you are borrowing money from the life insurance company.

When you need cash for a big expense, such as college tuition, a loan from your life insurance policy can be a saving grace. It can offer you advantages over credit card debt or personal loans from a bank. A loan from your insurance company is also much simpler to get than a bank loan, because it uses the cash value of your policy as collateral.

On the flip side, this option doesn't come without risks. If you do not pay back the loan, the insurance company will take it from the cash value of your policy or deduct it when the death benefit is paid out.

One of the main problems with this is that if the loan is not paid back, and you don't pay the interest either, then the interest will compound and be added to your loan balance. This amount may end up exceeding the policy's cash value over time.

Tip

Borrowing from your life insurance policy requires cautious planning and monitoring of your loan balance and cash value. Otherwise, you might risk losing your policy. This planning is where an in-force illustration will come in handy.

Do You Have to Pay Back the Loan?

Unlike bank loans or mortgages, you do not have to pay back the loan you take when borrowing from a permanent life insurance policy. But when you borrow the money based on your cash value, the amount you borrow may reduce the death benefit from your policy's life insurance portion.

If you do not pay the loan back, and the interest combined with the amount borrowed starts to exceed the cash value, you could put your life insurance policy at risk. This policy risk can arise more quickly than you think.

Why Borrow From a Life Insurance Policy vs. the Bank?

Policy loans don't make sense in all situations, but there are some advantages when compared to loans from traditional lenders.

Some people buy cash-value life insurance in order to build assets. That way, later in life, they can borrow from their policy or use the investments when they need to. Others choose to borrow from their policy to avoid the hassle of a bank loan.

In most cases, taking a loan from your life insurance policy allows more flexibility in repayment. Rather than making monthly payments to a bank on a fixed term, you can pay back as little or as much as you want, and at any time interval.

If you can repay your loan in a reasonable amount of time and keep up with the interest payments, this could be a good option. Your life insurance agent can help you figure out a plan.

Important

Before you borrow from a cash-value policy, make sure you have a discussion with your financial planner.

An Example of Borrowing From a Life Insurance Policy

Jane had been paying into her whole life insurance policy since she was 22 years old. When she turned 40, she decided she wanted to buy herself the sailboat of her dreams. She didn't want to take out a loan, so she planned to use some of her savings. She also planned to borrow the remaining $20,000 she needed from the cash value of her life insurance policy.

When Jane called to get the loan and discuss it with her financial advisor, she found out that she could borrow the money without a problem. But she also learned that the amount might reduce the amount of her death benefit. This reduction would mean that, if she were to die, her family would only get the death benefit minus the amount of the loan she hadn't yet paid.

Jane's advisor also explained that, even though she didn't have to pay back the loan, she could end up paying interest and compounded interest. When they worked out the details, Jane decided that the loan for the sailboat wasn't the best use of her accumulated cash value.

Instead, Jane chose to take money from her life insurance policy to start her own business. Because she had already done market research and had some demand for her services, she felt confident that she could pay back her loan within two years.

The Bottom Line

Borrowing from your life insurance policy could be a problem if you borrow the funds because you've fallen on hard times. In some states, the cash value in your life policy is protected from creditors. Still, any loan taken from your life insurance policy is considered cash, and this money would no longer be protected from debt collectors if it's in your bank account.

Don't take out a loan without having the big picture. The most important thing to know is that it's not the same as pulling money from your savings account. It's a complex transaction, and you need to make sure you understand all aspects of it.