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At some point in our formative years we’ve had a parent or caregiver say to us “just because your friend jumps off a bridge doesn’t mean you should.” Of course they were trying to teach us that just because you can do something doesn’t make it a good idea. Borrowing against the cash value of your life insurance is a lot like that. You can do it, but it’s not always a good idea.
On the other hand, borrowing against life insurance cash value isn’t necessarily a bad idea either.
You see, borrowing against cash value is not a black and white issue – it’s very much dependent on individual circumstances and goals. The best advice I can give is to read up on the expert advice out there – articles like my own – until you feel you’ve developed a solid understanding of the advantages and disadvantages of borrowing from your policy; only then can you make an informed decision that is based on your actual circumstances.
borrowing against cash value is not a black and white issue – it’s very much dependent on individual circumstances and goals.
As we’ve discussed in earlier articles, life insurance policies that build cash value, such as whole or universal life, are more costly than pure insurance term policies because part of that additional cost goes into building cash value. Building cash value takes time, but before you start building up your own, there are some risks you need to understand.
What is Cash Value?
Understanding cash value is vital to making an informed, effective decision. Cash value is a portion of your policy’s death benefit which has become liquid. It grows at different rates for different insurers. This is referred to as the rate of accumulation – the ROA. Universal life policies offer different options for how excess premium is invested, which will then result in a different rate of return for that policy.
if you borrow against it and die while the loan is outstanding, the death benefit is reduced by the amount of the outstanding loan
The risk comes from the fact that it is a part of your death benefit. This means that if you borrow against it and die while the loan is outstanding, the death benefit is reduced by the amount of the outstanding loan. So before you borrow against your accumulated cash value, one of the questions you should ask yourself is this:
If I die the day after I borrow the money, will there be enough death benefit left to fulfill my reason for buying the insurance in the first place?
It’s Not Free Money!
A very common misconception about borrowing money from life insurance cash value is that it is free money, a “no strings” and “no expense” sort of deal. This is simply not true. Life insurance companies are in business to make money, and when you withdraw cash value from a policy, the insurance company no longer has that money available to invest, cover overhead, or pay other beneficiaries claims, and so they charge interest to make up the difference.
Unlike a bank loan, you are not obligated to pay back a loan against your cash value; this might sound like a great deal – it’s not. The risk here is that the lack of a requirement to repay the loan means the loan never gets paid back. Interest on borrowed cash value will continue to accrue and eat away your death benefit, further reducing what will be there for your loved ones when you are gone.
Life insurance companies are in business to make money, and when you withdraw cash value from a policy, the insurance company no longer has that money available to invest, cover overhead, or pay other beneficiaries claims, and so they charge interest to make up the difference.
Borrowing from the cash value of your life insurance does have some upsides, the biggest of which is the tax advantage. Withdrawals of any amount from the accumulated cash value of your whole or universal life policy is tax free up to the amount of the premiums you have paid. As a rule, withdrawals generally includes loans.
This tax free status is a lifetime benefit which means that it will continue to be untaxed as long as you live, even if you do not repay it. However, the tax free status ends with your death; any outstanding balance at that time is taxable. It is always advisable to check with an accountant before moving forward. Tax laws and regulations are always changing and it is better be safe than sorry.
It Won’t Be There When You Need It
Life is uncertain and death is inevitable; removing cash value from your life insurance policy may leave you vulnerable to life’s uncertainties. An advantage of cash value beyond loans is that it can be used to pay premiums and therefore keep your insurance in place when you are unable to manage payments due to difficult financial circumstances.
When is a Good Time to Borrow?
There are times when conventional loans or credit are just not an option, such as when your credit is poor. If your only alternatives are high interest credit card advances, pay day loans or when interest rates are too high, your life insurance policy may be your best option. Bear in mind that a conventional loan is often a better choice in the long run, especially if you can get one at a low interest rate.
Borrowing against your cash value also makes perfect sense if you have a high cash value and are presented with an investment opportunity that generates a higher return than the interest on your loan. Of course you should remember that there really is no such thing as a risk free investment; you should carefully weigh the risks and possible rewards before withdrawing funds.
Of course you should remember that there really is no such thing as a risk free investment; you should carefully weigh the risks and possible rewards before withdrawing funds.
Other Ways to Get Money Out
Loans are not the only way to access the accumulated cash value of your whole or universal life policy – they are just the most common. Many insurers pay an annual dividend to policyholders. Insurance dividends are usually the money that is left over from all the premiums collected after overhead expenses and claims are paid. They are non-taxable because the IRS considers them a return of premium rather than a traditional dividend; so they are a great way to get some extra money out of your life insurance.
The other option is called Surrender Value. Generally speaking, after a policy has been in force for at least 3 years and the policy has accumulated some cash value, you can cancel the policy and take the surrender value in a cash payment. In the early years of a policy there are usually fees involved that will reduce the cash value. Another option is a life settlement, in which the policy is sold to a third party for a cash sale.
The more important thing to remember is that surrender means giving up the insurance. You get the cash value less any fees and the insurance is terminated. Unlike a loan, there is no interest or repayment but there is also no death benefit. Consider surrender as a last resort or if you have adequate insurance in place elsewhere.
One of the reasons you decided to buy a whole or universal life policy was the fact that it builds cash value and having the ability to borrow against it. The other and perhaps more important reason you purchased permanent insurance was to make provisions for those left behind after your death.