While term life insurance doesn’t build cash value, other types of life insurance do. Whole life insurance, for example, which is also called permanent life insurance, offers a death benefit but also builds cash value you can borrow against.
“Cash value life insurance” serves multiple purposes. Not only does it protect your family in the event of your death, but it can serve as a financial resource you can lean on when it makes sense.
Borrowing against cash value life insurance is not a black and white issue – it’s very much dependent on individual circumstances and goals. The best advice is to read up on the expert advice out there until you feel you’ve developed a solid understanding of the advantages and disadvantages of borrowing from your policy so that you can make an informed decision based on your actual circumstances.
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 making a decision on cash value life insurance, there are some important issues to understand.
What Is Cash Value?
Cash value is a portion of your policy’s death benefit that has become liquid. It grows at different rates with different insurers. This is referred to as the rate of accumulation, or the ROA. Universal life policies offer different options for how excess premiums are invested, which will then result in a different rate of return for that policy.
Cash value life insurance is a life insurance policy that not only has a death benefit, it accumulates some cash value in a separate part of the policy. The risk in borrowing against it comes from the fact that any outstanding loan balance is deducted from the 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, ask yourself this: If you die the day after you borrow the money, will there still be enough death benefit left to fulfill your reason for buying the insurance in the first place?
How Does Cash Value Life Insurance Work?
Cash value life insurance works by accumulating value in a separate account within the policy. Whenever you pay your premium, part of the money goes toward the cost of the insurance itself, part goes to cover the company’s overhead and profits, and part goes into a cash value account within the life insurance policy. This is separate from the policy’s death benefit, and is typically invested in a conservative-growth fund.
The cash value of a life insurance policy is the amount of money you would receive by surrendering the policy. The cash value serves as an investment, accumulating tax-deferred interest.
A beneficiary receives the death benefit, but does not receive the cash value in the policy. Any cash value that remains in the life insurance policy when you die is kept by the insurer.
Types of Cash Value Life Insurance Policies
Unlike term life insurance, cash value life insurance policies are permanent and will last for the remainder of your life as long as premiums are paid. Among the typical types of cash value life insurance policies are:
- Whole Life Insurance: This builds cash value at a fixed rate decided on by the insurer. It will reach the amount of the death benefit when the policy matures.
- Universal Life Insurance: This type of policy is based on market interest rates and how the insurer performs financially.
- Indexed Universal Life Insurance: This type of policy is based on the performance of an index like the S&P 500.
- Variable Life Insurance: In this type of policy, cash value can be invested in different options offered by the insurer, which are similar to mutual funds.
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” deal, which 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’re not obligated to pay back a loan against your cash value. The risk is that, because a payment isn’t required, the loan may never get 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’re gone.
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 are 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 on the safe side.
It Won’t Be There When You Need It
Removing cash value from your life insurance policy may leave you vulnerable to life’s uncertainties. The whole point of life insurance is to provide some financial stability for your loved ones if you pass away unexpectedly; if you borrow too much against your policy, it could hurt this goal.
However, one advantage of cash value beyond loans is that it can be used to pay premiums, and therefore keep your insurance in place when you’re unable to manage payments due to difficult financial circumstances.
When Does It Make Sense to Borrow Against Your Life Insurance Cash Value?
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, payday loans, or high-interest personal loans, 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, 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’re 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.
Another option is called surrender value. Generally speaking, after a policy has been in force for at least three 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. Finally, one other 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 only as a last resort or if you have adequate life 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 offers you the ability to borrow against it. But the other — and perhaps more important — reason you purchased permanent insurance was to make provisions for those left behind after your death.