Borrowing From a Life Insurance Policy
Good or Bad Idea?
Although traditional life insurance was originally developed to provide a death benefit to a beneficiary in the event of the insured person's death, several products evolved in the latter part of the 20th century that also incorporated a type of savings or investment component.
Some insurance salespeople tout the benefits of these types of life insurance policies, such as being able to borrow money from the cash value of the policy after you've paid premiums for a while. Two examples of life insurance policies that provide cash values are whole life insurance and universal life insurance. Check your life insurance policy to see if it includes a loan provision.
Being able to use your policy if you need an emergency loan sounds great, but it pays to understand all of the pros and cons of policy loans beforehand so that you don't put your policy and paid premiums at risk.
Can You Borrow Money From Term Life Insurance Policies?
Inexpensive life insurance policies such as term life insurance don't build any cash value, so they don't allow you to borrow money from the policy. Part of the reason term life insurance is considered affordable or cheap is that it is a pure life insurance policy; it has no value other than the actual death benefit to be payable upon the death of the insured if the insured dies during the fixed term.
Before You Borrow
If you have the option of borrowing from your life insurance policy, you probably own a policy that offers a cash value and used this feature as part of your strategy in deciding what kind of life insurance best suits your needs.
The first thing you need to do if you are considering borrowing money or withdrawing funds from your life insurance is to decide if it makes sense in your circumstance.
Ask your agent or representative to run an "in-force illustration" which will show you how taking a loan impacts your policy. Also, explore other options and weigh the pros and cons of borrowing from your policy.
Pros and Cons of a Policy Loan
When you need cash for an emergency or a big expense such as college tuition, a loan from your life insurance policy can be a saving grace, offering you advantages over credit card debt or personal loans from a bank.
On the flip side, this option doesn't come without risks. The snapshot of pros and cons below can help you decide if a cash-value loan fits your needs.
Skip the lengthy loan application process and just fill out a form to get your money.
Borrow without a credit check and no questions from a lender, if you have built up cash value in the policy.
Keep your credit report clean—policy loans don't show up on your credit report, unlike credit card debt or a bank loan.
Enjoy lower interest rates, ranging from roughly 5 to 8 percent, vs. average rates on personal loans or credit cards, which range from 10 to 13.9 percent or more.
Repay the loan on your own schedule.
Never repay the loan and just have it deducted from the policy's death benefit.
Enjoy protection from creditors for all of the cash value locked up in your policy.
You won't be able to take a loan for several years until enough cash value has been built up in the policy.
You can run the risk of a reduced death benefit for your family if the loan isn't repaid while you're living.
There's a risk of losing your policy if the amount of interest plus the unpaid loan adds up to more than the total amount of the policy's remaining cash value.
Income taxes may be due on the loan proceeds if the policy lapses and you didn't repay the entire loan.
There won't be any protection from creditors on your policy's cash value once you take it out in the form of a loan.
How Borrowing From a Life Insurance Policy Works
One of the greatest differences between policy loans and traditional loans is that you don't have to pay back the loan to your own insurance policy. When you borrow based on the cash value of your life insurance policy, you are borrowing money from the life insurance company.
A loan from your insurance company is a lot easier to get than a bank loan because they are using the cash value of your policy as collateral. If you do not pay back the loan, they 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, which may end up exceeding the policy's cash value over time. Borrowing from your life insurance policy requires cautious planning and monitoring of your loan balance and cash value or you might risk losing your policy. This is where an in-force illustration will come in handy.
When Can You Borrow From Your Life Insurance Policy?
You can typically borrow or take cash from your life insurance policy after you have built up the cash value. You will have to contact your financial planner or advisor, or your life insurance representative to find out what your cash value is and to discuss what the impact will be on your policy as well as potential tax implications.
Do You Have to Pay Back the Loan When Borrowing From Your Life Insurance Policy?
Unlike bank loans or mortgages, you do not have to pay back the loan you take when borrowing from a permanent life insurance policy. However, when you borrow the money based on your cash value, the amount you borrow may reduce the death benefit from the life insurance portion of your policy. 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 can happen more quickly than you think.
5 Things to Check Before Borrowing From a Life Insurance Policy
There are several factors to consider before you cancel or cash out a life insurance policy, borrow against it or take out the cash values.
Before you move forward on a policy loan, have a serious discussion with your financial planner or insurance advisor to understand the long-term and short-term consequences and risks.
There are many hidden costs that you may not initially realize, so it's important to make sure this is the best option for you.
- Discuss how the loan and interest will impact your life insurance policy to make sure that the death benefit portion of your policy is not threatened.
- Find out if you will have to pay an "opportunity cost."
- Make sure you can afford to pay the interest and other fees or figure out the strategy based on your specific policy that will make sense for you. Not all policies are the same and everyone's circumstance is different. Interest costs range from 5 percent to 8 percent will be compounded so you'll be paying interest on your interest.
- If you can not pay back the interest on your loan, think twice. The in-force illustration will help you understand this aspect.
- If you are relying on the dividends of your policy to pay the interest on the loan, have a real look at the details with your representative or financial advisor. Borrowing the policy's cash value reduces the amount of available collateral for the loan, which reduces the dividends and generates less money to cover the interest payments. This can be costly if not structured properly and could cause you to lose your policy.
All of these issues should come up when you look at the in-force illustration of the impact of your loan with your agent or advisor.
Reasons to Borrow From a Life Insurance Policy vs. the Bank
While policy loans don't make sense for every situation, you'll have a few advantages if you take a loan from your permanent life insurance rather than from a traditional lender.
- Some people buy cash-value life insurance specifically to build assets so that later on in life they can borrow from their life insurance policy or use the investments when they need to.
- Some people borrow from their life insurance policy to avoid the hassle of a loan from the bank. If you have the intention of repaying the loan in a reasonable amount of time and keeping up with the interest payments so they do not accumulate, then this could be a hassle-free option.
- Borrowing from your life insurance policy allows a lot more flexibility in repayment. For example, when you borrow from a bank, you have monthly payments to make over a fixed term, whereas if you borrow from your life insurance policy, you can pay back as little or as much as you want at any time interval. Again, you have to be careful how this impacts the value of your loan, vs. your cash value as interest accumulates, but if you only need a loan for a brief time, this can really help you borrow money and pay it back on your terms.
- If the amount you are borrowing is significantly less than your cash value and you have plans and the means to pay back the interest and value in a reasonable amount of time (your life insurance agent can help you figure this out), then borrowing from your policy will be a good option for you.
You can borrow from a cash-value permanent policy, but before you do, make sure you are prepared to manage the transaction properly by having a thorough discussion with your planner.
Beware of the Real Implication of Borrowing From Your Life Insurance Policy
The basic list of things to look out for works if you're considering borrowing from your policy, and can be used as a starting point to discuss the option with your licensed advisor or representative to make an informed decision. There are smart ways to manage borrowing from your policy that can provide good benefits, but there are also risks when not done with careful planning.
For example, borrowing from your life insurance policy could be a problem if you are borrowing the funds because you are having hard financial times. The cash value in your life policy is protected from creditors, but any loan taken from your life insurance policy is considered cash, and this money would no longer be protected from creditors.
The last thing you need is to take out a loan without having the big picture. What is most important for you to keep in mind is that this is not the same as pulling money out of a savings account; it's a complex transaction and you need to make sure you understand all aspects of it.
Example #1: Borrowing From a Life Insurance Policy
Jane had been paying into her whole life insurance policy since she was 22. On her 40th birthday, she decided that she wanted to buy herself the sailboat she had always dreamed of.
She was still paying off her home and didn't want to take out an additional loan, so she decided to use some of her savings, and borrow the remaining $20,000 she needed from the cash value of her life insurance policy.
When she called to get the loan and discussed the consequences with her financial advisor, she found out that she could borrow the money, but that the amount might reduce the amount of her death benefit. This would mean that if something happened to her and she died, her family would only get the death benefit, less whatever amount of the loan she didn't pay back.
That didn't bother her so much, but then her financial advisor went on to explain 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 the loan for the sailboat probably wasn't the best use of her accumulated cash value, and she decided to rent a boat instead and not risk paying all the fees and compound interest or risk her policy long term.
Example #2: Borrowing to Start a Business
Jane decided to pass on the boat and chose instead to take money from her life insurance policy to start her own business. She had never run a business before and was worried about borrowing from the bank. She also didn't want to have another loan on her credit report. Because Jane had already done some market research and had some demand for her services already, she thought she could manage to pay back her life insurance loan within two years. Borrowing the money was an investment in herself and the future business made sense, so she took out the loan.