In addition to providing money for your beneficiaries when you die, permanent life insurance policies build cash value that you can borrow against while you’re alive.
Borrowing against cash value policies offers advantages over traditional loans, says Matthew Carbray, a certified financial planner based in Avon, Conn.
“Borrowing from a life insurance policy can be a favorable way to get access to quick capital,” he explains. “Depending on the policy structure and underlying insurance vehicle, most policies will allow for a policy loan upwards of 90% of the current cash value.”
You can borrow against your life insurance policy for any reason, says Erick G. Colon, a financial advisor with Concord Wealth Management in Massachusetts.
“The loan can be used for any purpose, whether it’s for education, purchasing a home or car, or as a source of funds in the event of loss of income,” he says.
How Life Insurance Policies Build Cash Value
While term life insurance policies remain in effect for fixed periods, permanent or cash value insurance covers you for your entire life.
These policies typically cost more than term life, but a portion of the premiums is invested. Money earned from the investment creates a cash value that can be borrowed against.
When you borrow against a cash value policy, “you’re basically borrowing your own money,” says Emory J. Smith, founder of EJS Financial Management in Phoenix.
Benefits of Borrowing Against Life Insurance
There are a variety of reasons to consider borrowing against your cash value life insurance policy. They include:
Greater flexibility. These loans give borrowers many options. Your policy’s cash value becomes the collateral for the loan, so you can decide how to use the money. Investopedia notes that insurance companies typically require no explanation.
Reduced interest rates. The interest rates on cash value loans often are lower than the rates you’ll receive from credit cards and personal loans. Personal loans typically have high interest rates. The average rate for a 24-month personal loan was 9.65% in August 2016, according to the Federal Reserve.
No credit check required. One of the advantages of a cash-value loan is you don’t have to have your credit checked, says Aron S. Brodt, a financial services professional based in Brooklyn, N.Y. If you have cash value in your life insurance policy, you can borrow against it, even if you have bad credit otherwise. You can’t be turned down because of a lack of creditworthiness.
Repay it whenever you like. You can set your own timetable for repaying the loan. However, if your policy lapses before the loan is retired, you may owe tax on some or all of the portion that hasn’t been repaid, says Smith.
Drawbacks of Borrowing Against Life Insurance
While borrowing against your cash value life insurance has benefits, there also are potential drawbacks:
You’ll decrease your assets. It’s important to make sure the loan is truly necessary. Once you take out a loan against your life insurance policy there will be fewer assets to borrow against in the future.
Your policy may be at risk. Remember that the interest on this type of loan typically is subtracted from your permanent life policy’s cash value. Once the loan and interest exceed the value of the policy, it can lapse. If that happens, “there is the possibility of a taxable event,” says Carbray.
Your death benefit may decline. If your dependents are counting on your life policy for support, be aware that an outstanding loan at the time of your death typically will reduce the benefit, says Smith.
Cash value builds slowly. Before you can borrow against a permanent life insurance policy, it must build value. In the early years of your policy, there may be little value for you to borrow against.
Will You Benefit from Borrowing Against Life Insurance?
This type of loan may be a good alternative for people who face unexpected debts and don’t want to take out more costly personal loans or increase their credit card balances.
Before you take out the loan, though, consider consulting a financial advisor who can help you decide if this is your best option for raising the money you need.
Don’t forget that the original purpose of your life insurance was to provide a death benefit. If you die before you repay the loan, your insurance company will repay the debt by reducing the payout to your beneficiaries.
“In general, a policy owner should only borrow against their policy if they intend to repay the loan or they are certain the policy will not lapse prior to their death,” Smith says.