Can You Borrow Against Life Insurance?Everything you need to know about life insurance policy loans and if they are the right option for you.
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A lot of people don't know that they can borrow money against the cash value of their whole life insurance policies.
While this may sound great, it's important to look at the advantages and disadvantages of borrowing money through your life insurance.
This article will cover life insurance-backed loans, how they work, the pros and cons, and what happens when you don’t pay them back.
What Is Cash Value Life Insurance?
Cash value life insurance plans are whole life policies that allow policyholders to add and keep additional money in their life insurance policies. This money is known as cash value and can be accessed by policyholders through life insurance loans.
What Is Cash Value?
Cash value is the portion of your life insurance policy that earns interest and may be available for you to withdraw or borrow against in case of an emergency.
A part of your premium goes into a separate account that grows in value over time and when there’s enough money (usually after the 10th year the policy is in force) you can use it to:
Buy more coverage to increase your death benefit.
Pay your policy’s premiums.
Borrow money through your insurance company. The cash value is used as a form of collateral. You can also go to the bank and use it as collateral.
What Is Collateral?
It is something that someone gives as security for repaying a loan. If they don't manage to repay the loan, they'll have to give the security up as payment instead.
Can You Borrow Against Your Life Insurance Policy?
A traditional or permanent life insurance policy provides permanent death benefit coverage for the life of the insured.
With permanent life insurance, a portion of each premium you pay goes toward insuring your life, and you can choose to add to your policy's cash value. The cash value portion of your policy gains tax-deferred interest.
Your policy’s cash value grows over time at a rate that is set by the terms of the policy. There are, however, some exceptions to this rule. For example, this option is usually only available when your life insurance policy's cash value has reached a certain amount.
Permanent Life Insurance vs. Term Life Insurance
Term life insurance is a form of life insurance that provides coverage for a set period of time, or "term".
Unlike permanent life insurance, which offers more comprehensive coverage and benefits, term life insurance is generally less expensive and is intended to provide protection for a specific need.
Term life insurance is a type of life insurance policy that provides coverage for a certain period of time (usually 10, 20, or 30 years). If the insured dies during the time period specified in the policy and the policy is active, a death benefit will be paid.
You can't borrow against term life insurance policies, because they don't have a cash value component. So, if you decide to surrender a term life insurance policy, you won't receive money in return.
How Much Can You Borrow from a Life Insurance Policy?
The amount you can borrow from a life insurance policy will depend on your coverage amount and cash value amount. However, the maximum amount you'll generally be allowed to borrow is 90% of the cash value, with no minimum amount specified.
With a policy loan, you don't borrow money out of your cash value. You're taking out a loan from the insurance company and only using the cash value as collateral.
This is a big advantage because the cash value of the life insurance policy stays there and still earns interest.
You also won’t have to pay back the money within a certain amount of time, as is the case with other types of loans.
However, if you don't pay the insurance company the annual interest—which can be fixed or variable—the interest payment will be added to the principal debt.
What Is Principal Debt?
Principal debt is the amount of money that you borrow when taking out a loan or line of credit. It typically consists of both the principal and interest amounts, and it can be paid off through monthly payments over time.
Keep in mind that if you don't repay the policy loan your life insurance policy could lapse, regardless of whether you keep up with the life insurance policy premiums, and you would no longer have life insurance coverage.
How Do You Take Out a Life Insurance Policy Loan?
Taking out a life insurance-backed loan is quite simple. All you have to do is fill out a form from your insurance company. Typically, the money will be deposited into your account within a few days.
In some cases, before getting your loan, you might have to confirm your identity, sign a confirmation document, or get it notarized, if:
Within the last month, you informed the insurance company that you will change your payment method.
The owner of the policy changed recently.
The amount of the loan exceeds a specific amount (such as $50,000).
While it may sound complicated, your insurance company will usually walk you through the process step-by-step so that there is no confusion.
Pros and Cons of Taking Out a Life Insurance Loan
Before taking out a life insurance loan, it is important to understand the pros and cons of using your life insurance to borrow money.
On the one hand, a life insurance policy loan can provide you with access to funds when you need them, allowing you to cover unexpected expenses or deal with financial emergencies.
On the other hand, there are also potential drawbacks, including high-interest rates and fees, as well as the possibility that borrowing against your life insurance policy could lead to it lapsing.
Pros of Taking Out a Life Insurance Loan
Interest rates are lower: Life insurance policy loans will generally have lower interest rates than bank loans or credit cards.
The average interest rate on a life insurance loan is between 7% and 8%, according to the Federal Reserve data for 2022.
The average personal loan interest rates range from 10.3% to 12.5% for “excellent” credit scores of 720 to 850.
The average interest rate for a credit card is 19.62%.
There is no credit check: If you have enough cash value, you can borrow from a life insurance policy with no questions asked. The formal application process is different from bank loans and credit cards.
There is still a fair amount of underwriting, verification, and affordability assessment involved. However, unlike credit card debt, a policy loan doesn't show up on your credit report.
There is no time frame for repayment: You can repay the life insurance loan in your own time. Technically, you aren't required to repay the loan, but the outstanding amount will be deducted from the policy's death benefit if you don’t and you may even lose your coverage.
Cons of Taking Out a Life Insurance Loan
Risk of reduced payout and losing coverage: One of the biggest downsides of using your life insurance policy to borrow cash is that your death benefit will be reduced if you don’t repay the loan during your lifetime.
The rates of a life insurance-backed loan may be favorable, but you still pay interest on it. This interest can also sneak up on you because it is often simply subtracted from the cash value.
You also risk your policy lapsing if your loan plus interest exceeds your insurance policy’s cash value.
You may not qualify yet: You need a certain amount saved up as cash value to qualify for a loan. Depending on your policy, this takes at least ten years to build up and in the early years of your policy, there may be little value, if any, to borrow against.
Possible tax consequences: If your policy lapses before your loan is fully repaid, you could owe tax on some of the money you haven’t paid back.
If added interest increases the loan value beyond the cash value of your insurance, your life insurance policy could lapse and be terminated by the insurance company.
In such a case, the policy loan balance, as well as its interest, becomes taxable income and could add up to a hefty amount.
What Is Added Interest?
Added Interest is a method of calculating the interest to be paid on a loan by adding the total amount borrowed to the total interest due to arrive at a single amount. This is then multiplied by the number of years needed to repay the loan.
Taking out a life insurance policy loan is not the right choice for everyone, and it is important to carefully consider the potential consequences. However, for some people, life insurance loans can be a helpful way to access the money they need.
Should You Borrow from Cash Value Life Insurance?
Depending on your situation, it might be better to take out a loan against your life insurance than to run up your credit card debt or pay high interest on a personal loan.
However, borrowing money from your life insurance company carries some responsibilities and consequences. These include:
Monitoring how much interest has built up and how much has been paid on your debt.
Setting reminders and deadlines to pay back the loan.
Making sure that you pay back the loan in full, especially if your family needs the full death benefit.
With some careful planning and commitment, life insurance loans can be a valuable tool to help manage your finances while still providing protection for your family in the event of your death.
If you're interested in learning more about life insurance loans, speak to a life insurance agent today.
Where Can I Learn More about Different Life Insurance Policies?
Borrowing money against your life insurance policy has some benefits when compared to personal loans, business loans, and credit cards. However, you need to make sure it is the right option for you.
To learn more about life insurance policy loans and other life insurance topics, head to PolicyScout’s life insurance hub.
We have loads of articles that will help you understand life insurance policies, their cash values, borrowing against them, and enrollment options.