Borrowing Against Your Life Insurance Policy

Assuming you have a life insurance policy with cash value (like whole life insurance), you can borrow against your life insurance policy at any time and for any reason. A life insurance policy loan is different from a bank or credit card loan in certain aspects, such as:

• It does not affect your credit score

• There is no credit check or approval process because you are basically borrowing from yourself

• You do not need to explain why you are borrowing or how you plan to spend the money. So, you can take out a life insurance policy loan for anything, from covering a financial emergency to taking a vacation

• The loan is not subject to tax, provided it does not exceed the amount paid in premiums and your life insurance policy is in force

• There are no mandatory monthly payments, and you do not have to repay the loan in a predefined period. In fact, you are not even required to pay the life insurance loan back, but that does not mean the insurer will forget about it. If you do not pay back the loan, the insurer will take it from your life insurance cash value or deduct it from your death benefit when you die

To take out a life insurance policy loan, get in touch with your insurer. If your life insurance policy has accumulated enough cash value, you can expect a speedy approval.

There will be interest on the borrowed amount. Interest rates vary by life insurance company, though typically it is around 6% per year. Typically, the policy loan rate is much lower than interest rate on a credit card or bank loan.

The interest rate may be either fixed or variable. With a fixed rate, you know in advance how much interest you will pay each year. Variable interest rates, on the other hand, change annually and are usually listed on your life insurance policy’s annual statement.

The insurer will charge you interest in arrears or in advance.

• Interest in arrears. You will pay interest on the amount borrowed at the end of the life insurance policy year. Interest accrues daily and starts accumulating from the day you take out the loan.

• Interest in advance.  You will pay interest for the year in advance. If you take out a loan in the middle of the life insurance policy year, there will be interest for the rest of the policy year.  

You will still earn gains on the money that you have borrowed. The insurance carrier will pay you interest and dividend (in the case of a participating policy) on the loaned amount. Depending on your life insurance policy, this interest and dividend rate may be lower or the same as the interest rate and dividend credited on the remaining cash value.

How much can you borrow against your life insurance policy?

How much money you can borrow against your cash value varies from one insurer to the next. All the same, most insurers let you borrow amounts as high as 90-95% of the life insurance cash value.

Since the insurer uses the cash value as collateral, the loan is approved rather quickly, without any credit check or lengthy procedures. The insurer will not ask you to pay it back within a set period. However, keep in mind that interest will be added to your loan amount. So, the longer you defer repaying, the greater the outstanding loan amount will be. If the outstanding loan amount exceeds the cash value, your life insurance policy will lapse, terminating your coverage.

Should you borrow from your life insurance policy?

If you are short on cash and need funds to pay for a financial emergency or other expenses, one option is borrowing from life insurance. But the question is, should you?

There is no one-size-fits-all answer. It all depends on your situation. Ask your life insurance company to provide an “in-force illustration.” It will show how a life insurance policy loan will affect your policy. Take a policy loan only if the pros outweigh the cons.  

Some of the things to consider are:

• Check how the life insurance policy loan and interest will impact the life insurance policy. Make sure your death benefit will not be eroded, especially if you have people who financially depend on you.

• Ensure you can afford the loan and interest. While repaying the loan is not compulsory, not paying it will have consequences. Make sure you are okay with them if you plan not to repay or to repay only a part of it.

• The insurer will charge a compound interest rate. If you do not pay off the interest debited, you will be paying interest on interest.

Generally speaking, taking a life insurance policy loan can make sense if:

• You do not have any better option available for raising cash.

• Your family no longer needs the death benefit.

• You plan to borrow only a small portion of your cash value.

• You plan to repay the loan soon.

Advantages of borrowing against your life insurance policy

Here are six benefits of borrowing from life insurance:

1. Easy Access

With a poor credit score, getting a personal loan is anything but easy. That is not the case, however, with a life insurance loan. Because the insurer uses the life insurance policy’s cash value as collateral, it does not run a credit check. Having enough cash value is the only qualification needed for approval. The loan application process, too, is short and simple.

2. Does not hurt your credit score

When you apply for a personal loan, the lender pulls a hard inquiry — checking your credit report to evaluate credit worthiness. Every such inquiry can temporarily shave a few points off your credit score. This might not be a big deal for someone with an excellent credit score. But if you credit score is modest to begin with and approval is not guaranteed, every hard inquire can impact your score.

A life insurance policy loan, in contrast, does not require a credit check. So, it does not hurt your credit score. Nor does it show up on your credit report, which can be especially helpful if you are looking for additional funding.

3. Low Adjusted Interest Rate

Borrowing from life insurance is essentially a loan, so there will be interest on the loaned amount. But since your remaining cash value continues to earn gains, the adjusted rate is much lower than you would pay on a comparable credit card or bank loan.  

For example, say you have $60,000 in cash value — which grows at a rate of 6% — and you take out a life insurance policy loan of $30,000 at 6%. Since $30,000 is still left in the account, the effective interest rate on the policy loan will be zero percent.

4. Flexible Terms and Loan Amount

When you take a life insurance policy loan, you can pick a payment schedule that best suits you. If needed, you can even modify it later. And if you find you cannot repay the loan, you do not have to. However, you may face tax consequences if your life insurance policy lapses. Traditional loans, like credit card or bank loans, however, do not offer such leeway.

In addition, there is a limit as to how much of a personal loan you can get. Most personal loans range from $2,000 to $50,000. But when it comes to borrowing from life insurance, you do not have to worry about such caps.

How much you can borrow depends on how much cash value your policy has. The greater the cash value, the more money you can borrow. Most insure issue loan amounts as high as 90-95% of the policy’s cash value.  

5. Tax-free Loans

Insurance loans are tax-free, as long as your life insurance policy is in force and the amount you borrow does not exceed the amount you contributed.

6. No Origination Fees

Typically, you do not have to pay an origination fee when you borrow against cash value. Consumer loans, however, usually charge this fee.

Disadvantages of borrowing against your life insurance policy

Even though borrowing from life insurance has some advantages over consumer loans, it is not free of pitfalls. Here are the main disadvantages of a cash value loan.

1. You can lose coverage if you cannot repay

If you do not repay the loan, the insurance carrier will take the money from your life insurance policy’s cash value. And when the cash value depletes, your coverage will lapse. If you pass away before paying the loan, the life insurance company will deduct the outstanding balance from the death benefit. In other words, your beneficiaries will get a smaller payout than you wanted them to receive. If the primary purpose for taking a policy was to provide your family with a safety net, your decision to not repay can hurt them badly.

2. The amount available to borrow is negligible during the initial years.

Permanent life insurance policies accumulate cash value slowly picking up the pace. The amount available to borrow for the first 5 to 8 policy years is likely to be small. Generally, it takes about 10 years or so for a life insurance policy to build sufficient funds to make borrowing worthwhile.

3. Possible tax consequences.

While life insurance policy loans are typically tax-free, they can be subject to tax in certain situations. For instance, if you borrowed more money than you paid in premiums and the policy terminates, you will get a tax bill. You will not have to pay tax on the entire loan amount, though. Instead, only that portion of the loan that exceeds the total amount you contributed to the policy will be taxable.  

Here is a simplified example. Let’s assume your life insurance policy is 12 years old, during which time you have paid $18,000 in premiums. Your policy’s cash value is $20,000 and you decide to borrow all of it. If you miss a single premium payment, your policy will lapse. Moreover, you will receive a tax bill for $2,000 — the difference between the borrowed amount and the total premiums paid.

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4. Depletion of an emergency fund

Your policy’s cash value can help keep the life insurance policy active if you cannot pay premiums. However, if you borrow a sizeable portion of the cash value, there might not be enough reserves to provide this cushion. Your life insurance policy may lapse after the first or second unpaid premium.

Repaying the insurance policy

Paying back the loan taken against your life insurance policy’s cash value is optional. However, if you do not repay, either of these scenarios may play out.

• If you do not pay back the loan, you run the risk of losing coverage if you stop paying premiums

• If you never repay the loan during your lifetime, your beneficiaries will. The insurance carrier will reduce the death benefit by the amount you borrowed, which means your loved ones will receive less money than you intended

If you decide to repay, you are free to construct a repayment schedule that works best for you. Also, you can make periodic payments with annual interest or pay only the annual interest. In the latter case, the principal amount will be deducted from the death benefit when you pass away.

Conclusion

Borrowing from life insurance can give you access to quick cash, no questions asked. However, a life insurance policy loan can impact your life insurance policy in many ways. So, weigh the pros and cons carefully before making a decision.