Is Borrowing Against Life Insurance a Good Idea?
Life insurance is an excellent way to financially protect loved ones. It offers security to beneficiaries in the event of the policyholder’s death. Some life insurance policies can do much more than that. 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. And many life insurance providers allow customers to take out loans against their policies. These loans are easier to get than bank loans, and they generally come with lower interest rates. If you need a quick cash advance, borrowing against life insurance could be a good option. However, there are drawbacks. Policyholders who borrow carelessly could jeopardize their life insurance policy.
Before borrowing from life insurance, have a gameplan to pay back the amount. We’ll go over the process of borrowing against a life insurance policy, when it’s a good idea and how to avoid pitfalls.
“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.
Can I borrow from my life insurance policy?
Not all life insurance policies allow borrowing. For a policyholder to qualify for a loan, they’ll need a permanent life insurance policy, which are also referred to as cash-value policies. Term life insurance policies do not have a cash value unless the policyholder dies within the term.
People with cash-value life insurance policies can take out a loan against their policy but only after the paid premiums reach an amount determined by the provider.
These loans are relatively easy to recieve. Unlike many loans, a loan from a life insurance policy doesn’t have a deadline to be paid back. In fact, a loan against life insurance doesn’t need to be paid back at all. However, failing to pay back the loan will come with severe repercussions.
Before anyone borrows against their life insurance, have a solid plan for repayment.
How can I borrow from my life insurance?
While a term life insurance policy is only valuable in the event of the policyholder’s death within the stated term, participating, or cash-value, life insurance policies retain value in the form of a cash account.
The cash value in a participating life insurance policy is built up over time. Part of the premium the policyholder pays goes to the cost of insurance, and part of the premium goes into an account.
When borrowing against a life insurance policy, the policy’s cash value is not used for the loan. Instead, the cash value is used for the loan’s collateral. The insurance company loans the money to the policyholder.
The amount that can be borrowed against the policy’s cash value depends on the provider. Many life insurance companies allow their policyholders to borrow up to 90 percent of the policy’s cash value. There is usually no minimum amount that can be borrowed against the policy’s cash value.
Unlike many standard bank loans, policyholders don’t need to offer any explanation of why they need the loan.
Although life insurance loans have a lower interest rate than many bank loans, borrowing against a life insurance policy still comes with interest. Some providers charge compound interest on loans, so policyholders who don’t repay the loan quickly could pay interest on interest without paying off the loan’s principal.
Over time, the loan will accrue more interest. If the loan is not paid off, the interest will build up and supersede the cash value of the policy that was the collateral. If the loan becomes higher than the collateral, it could affect the death benefit of the life insurance. When that happens, the entire policy could become less valuable due to the lapsed interest payments.
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
Borrowing against life insurance provides many advantages over a traditional bank loan, including the ease of qualifying and the generally lower interest rates. Because of these advantages, policyholders could be tempted to take out loans without much foresight.
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.
However, getting a loan against an insurance policy should not be taken lightly. The interest rate builds up fast and can eat up the value of the overall policy.
People will only benefit from borrowing against life insurance if the loan is paid back as fast as possible. Because of this, emergency situations are the main instances when it would be appropriate to take out a loan against life insurance.
If the loan is allowed to grow, it will defeat the purpose of the life insurance by consuming the death benefit through unpaid interest.
Whole life, universal life and variable life insurance policies can have cash value. Each of these policy types handle cash values differently, so it’s important to understand the details of the policy before borrowing.
If a policyholder needs money from their life insurance policy, there is another option besides taking out a loan. Instead of borrowing against a policy’s cash value, the policyholder can withdraw money from the cash account.
This money will not need to be paid back and will not generate interest. However, it will permanently lower the death benefit of the insurance policy. If the policyholder has no plan to pay back the loan, then withdrawing money from the policy’s cash value is a better option.
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.