Borrowing From Life Insurance Policy: What You Need To Know
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Summary:
Borrowing from life insurance — known as a life insurance loan — is an easy way to get cash immediately without the high interest rates of bank loans and credit cards. However, there are a few potential downsides, including reduced benefits and the possible loss of your life insurance policy altogether, so it’s important to understand the rules of life insurance loans before you consider this option.
They say life is what happens when you’re busy making plans. So what should you do if an emergency comes up and you need cash now? You could apply for a bank loan, but the approval process is too long. You could sell your stocks, but the stock market may be in decline. You could max out your credit cards, but the interest rates are outrageous and your credit score will suffer.
One option you may not have considered yet is to borrow money from that life insurance policy you’ve been paying into for decades. This is known as a life insurance loan. Some of the advantages of life insurance loans include low interest rates, a quick approval process, and no credit check. However, there are also drawbacks to consider, such as premiums and reduced death benefits.
Read on to learn more about how life insurance policy loans work and whether this method of borrowing money may be a good option for you.
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Life insurance terms to know
Before we get into how life insurance works, here are some of the key terms you’ll need to know:
- Policy. This is the industry’s term for a life insurance contract.
- Policyholder. This is the owner of the insurance policy, or the person whose death is covered by the contract.
- Beneficiary. This is another term for heir. Beneficiaries are the people who receive the money from a life insurance policy after the policyholder dies.
- Death benefit. This is the amount of money the beneficiaries will receive in the event of the policyholder’s death.
- Premiums. While some insurance policies can be bought with a lump sum upfront, most are paid for in installments over time. These are known as premiums and are generally made on a monthly or quarterly basis.
- Cash value. This refers to the accrued interest on permanent life insurance policies. As interest accrues on the cash value portion, the amount required to cover the death benefit decreases, until eventually, the policy generates enough cash value to cover the death benefit itself.
- Annuity. This is another insurance product that serves as a form of income replacement. In some cases, a life insurance policy can be converted into an annuity to provide income for the insured.
- 1035 exchange. Insurance policies offer some protection from income taxes. A 1035 exchange allows policyholders to switch insurance policies without having to pay taxes on the change.
- Riders. These are features unique to the policy you are buying, which usually come at an extra cost.
The basics of life insurance policies
If you’re considering taking out a life insurance policy loan, it’s worth first understanding how life insurance works. Basically, when the owner of a life insurance policy dies, the life insurance company provides a lump sum of cash to the deceased’s beneficiaries.
The purpose of this death benefit is to serve as a form of income replacement. For example, imagine you’re the sole breadwinner in your family and you take out a life insurance policy worth 15 times your annual income. In the event of your death, your family can reinvest the lump sum they receive from your policy to generate an income similar to the one you can no longer provide.
Example of how a life insurance policy works
To better illustrate this point, let’s consider the imaginary case of Fred and Wilma. Fred is a young man who earns $70,000 a year, while his wife Wilma runs the household and raises their children. Fred wants to make sure his family is always taken care of, so he buys a whole life insurance policy with a death benefit of $1,000,000.
Some years later, Fred dies, and Wilma and the children receive a check from the life insurance company for $1,000,000. Wilma reinvests the money to earn a 7% return on bonds and certificates of deposit. This generates an income of $70,000 a year for her and the children, while the principal amount of the death benefit remains intact. Thus, Fred’s life insurance policy continues to provide for his family even while he himself no longer can.
Pro Tip
Some employers offer group life insurance as a benefit to their employees. However, this policy only covers current employees, and you may not be employed at the company when that insurance coverage matters most. Because of this, it’s generally a better idea to buy your own life insurance.
Types of life insurance policies
There are three main types of life insurance: whole life insurance, term life insurance, and universal life insurance. Let’s take a closer look at the major differences between them:
Whole life insurance
Also known as permanent life insurance, this is basically the vanilla flavor of life insurance policies: simple yet popular. Part of your premium goes toward the policy’s death benefit, while the rest is set aside for cash value growth. Because of this added benefit, whole life insurance is also sometimes referred to as cash value life insurance.
Because you’re paying for both a death benefit and a cash value component, whole life insurance is generally one of the more expensive options. With whole life insurance, your premium is also set from the beginning, and you’ll continue to pay for the policy for the rest of your life (or as long as you choose to keep it).
Term life insurance
While whole life insurance has two benefits, term life insurance only has one: your entire premium goes toward the death benefit, so the policy does not accumulate cash value. Term life insurance also only lasts for a set period; once the policy ends, you need to buy another policy to be covered for another term.
Term life insurance policies tend to cost less than whole life insurance because they’re more limited. Unlike a permanent life policy, a term life insurance policy only provides coverage for about ten to thirty years. Note that if you choose to purchase another term policy, it will be more expensive than the previous policy because the life insurance company will consider your advanced age a greater risk factor.
Universal life insurance
Universal life insurance is similar to a permanent life insurance policy in that it comes with a death benefit and a cash value component. However, while traditional insurance policies set a fixed amount for your scheduled premium payments, universal life insurance policies are more flexible to accommodate fluctuations in your financial situation. This means you can make larger payments in a good year (to increase your cash value) and make lower payments in a poor year (using your accrued cash value to cover internal fees).
With a universal life insurance policy, the insurance company pays a variable rate of interest on your accrued cash value. Some policies may also allow you to invest indirectly in the stock market, in which case your rate of return will be determined by the overall performance of your investments.
Pro Tip
Life insurance can be customized to fit your needs. Find an insurance agent you trust who can help you choose a policy with the features that matter most to you.
How do life insurance policy loans work?
Now that we’ve gone over the basics of life insurance, it should be easier to understand how a life insurance policy loan works.
Imagine an emergency expense comes up and you need a lot of cash to cover it right away. You don’t have that much money in your savings account at the moment, you don’t have time to wait for a bank loan to be approved, and you can’t afford the high interest rates that come with credit card debt. However, you do have that life insurance policy that you bought over ten years ago, so you decide to borrow money from that. This would constitute a life insurance loan.
It’s important to note that life insurance loans can only be taken out against whole or universal life insurance, not term life insurance. This is because you’re borrowing from accumulated cash value, which term life insurance doesn’t have. The amount you can take out for a loan will vary by insurance company, but in some cases, you may be able to borrow as much as 90% from your cash value account.
Like any other loan, a life insurance loan accumulates interest, though these interest rates are typically lower than those on other personal loans. While you don’t need to pay back the borrowed amount on a set schedule, you should continue paying premiums on your life insurance, or else you risk exceeding the policy’s cash value in debt and losing the policy altogether. That’s why it’s important to have a payment plan in place both for covering the premiums and repaying the loan before you borrow money from your life insurance policy.
Pros and cons of life insurance loans
Borrowing against a life insurance policy is one of multiple options you can use to access cash quickly, but is it the right option for you? Let’s take a look at the advantages and disadvantages of life insurance policy loans:
Pros of a life insurance loan
The following are some of the upsides of borrowing money from a life insurance policy:
- Quick approval process. Because you are borrowing money from an asset you already own, it’s much easier to get approved for a life insurance policy loan than a traditional personal loan.
- No credit check. There is no credit check when you apply for a life insurance policy loan, so it won’t affect your credit score.
- Lower interest rate. Using an asset you own, like a life insurance policy, as collateral means you can get a lower interest rate on your loan balance than you would with other types of credit.
- Tax-free lending. Borrowing from yourself doesn’t count as income, so you won’t owe taxes on the loan.
- Flexibility. Instead of a fixed repayment schedule, you can choose when to pay back the loan.
Cons of a life insurance loan
Before you apply for a life insurance loan, here are some of the drawbacks you should consider:
- Impact on cash value. If you choose not to make regular interest payments on the loan balance, the insurance company will deduct that interest from the cash value portion of the policy, effectively reducing how much the policy is worth.
- Premiums. On top of paying back the loan, you’ll also need to continue to pay premiums on your policy; otherwise, the insurance company will deduct administrative fees and the cost of the death benefit from your cash value account.
- Reduced death benefits. If there is still an outstanding loan balance at the time of the policyholder’s death, then the outstanding loan amount will be deducted from the beneficiary’s death benefit.
- Risk of policy lapse. If you fall behind on your premium and loan payments, you risk exhausting your policy’s cash value to cover those costs. In that case, your policy lapses, which means you’ll lose your insurance coverage and may even owe taxes on the loan balance.
Alternatives to life insurance policy loans
Maybe you’ve decided that the downsides of life insurance loans outweigh the benefits and it’s not worth the risks to borrow money from your life insurance policy. That said, you still need cash as soon as possible. So what other options are available to you?
Personal loans
A regular personal loan is an alternative to borrowing from a life insurance policy, and it’s worth considering the benefits of this option.
One of the main benefits of a personal loan is that it doesn’t require collateral. This means that you don’t have to put up any assets, such as your home or car, as security for the loan. This is in contrast to a life insurance policy loan, where you are borrowing against the accumulated cash value of your policy.
Another advantage of a personal loan is that it doesn’t affect your life insurance policy. When you borrow from your life insurance policy, you risk reducing your death benefit and possibly even losing your policy altogether. With a personal loan, you don’t have to worry about the impact on your life insurance coverage.
Personal loans also offer more flexibility when it comes to repayment. Unlike a life insurance policy loan, which may not have a set repayment schedule, personal loans come with a fixed repayment period, which allows you to budget and plan accordingly. Additionally, personal loans often have lower interest rates than credit cards, which makes them a more affordable option for borrowing money.
One of the downsides of a personal loan is that the approval process can take longer than a life insurance policy loan. You may need to provide documentation, such as proof of income, employment, or credit history, before your loan application is approved. Additionally, your credit score will be a factor in determining your interest rate and eligibility for a personal loan.
Sell your life insurance policy
If you’re over the age of 65 and unable to keep up with your premium payments, you might consider selling your life insurance policy to a third party. This practice is known as a life settlement. A life settlement provider buys your whole life insurance policy and gives you an immediate payout, then they take over the premium payments and collect the death benefit when you die.
Be aware that payouts will vary by broker, so if you’re thinking about selling your life insurance policy, it’s a good idea to shop around for the best deals before you agree to a life settlement.
Cash surrender value
Did you know that even if you terminate your whole life insurance, you get to keep the cash value of the policy? If you need money now and you no longer wish to leave a death benefit to any beneficiaries, another option you may want to consider is cash surrender value. Basically, once you terminate your policy, the insurance company will stop collecting premiums and send you a check for the cash value in your account.
Note that cash surrender is typically subject to fees, so you won’t receive the full amount of your cash value when you terminate your policy. The good news is that these fees decrease over time, so the longer you wait to terminate your policy, the more cash value you will receive.
Accelerated death benefit rider
Depending on how old you are, you may remember a time when ice cream only came in three flavors: chocolate, vanilla, and strawberry. You may also have been surprised one day to discover you could walk into an ice cream shop and see 31 flavors to choose from, and that’s even before you got to all the fun new toppings!
Life insurance works in a similar way: while there are a few common types of life insurance policies that have been around for a long time, these days you can often customize those policies to fit your specific needs. These policy add-ons are known as riders.
If you anticipate needing money sooner than later, you can purchase what’s known as an accelerated death benefit rider, which will give you access to some of the death benefit money from your policy before you die. This rider is typically only available to policyholders who are diagnosed with a serious or terminal illness, so if that’s the case for you, this could be a good way to get the money you need right away.
FAQ
How much money can I borrow from my life insurance?
That depends on how much cash value you have accumulated in your account. Typically, you can borrow up to 90% of your total cash value.
Do you have to pay back the money you borrow from life insurance?
Yes, like with any other type of loan, a life insurance loan must be paid back. Throughout the loan repayment period, the loan will generate interest on your accumulated cash value. If there is still an outstanding loan balance at the time of your death, that amount will be taken out of the death benefit.
What happens when you take out a loan on your life insurance?
When you take out a life insurance loan, the insurance company will send you a check for the amount secured by the cash value in your life insurance policy. You will then be responsible for staying on top of the policy’s premium payments and fees while you pay back the loan balance. Whatever payments you miss will be deducted from your cash value.
Which types of life insurance policies can you borrow against?
Because life insurance loans are always secured by a cash value component, policyholders can only borrow against permanent life policies, such as whole life insurance and universal life insurance.
What is the interest rate on a life insurance loan?
A life insurance loan interest rate is generally lower than the interest rate on an unsecured bank loan. It often varies by insurance company and the general lending market, but you can expect the interest rate on your life insurance loan to fall between 5% and 9%.
How soon can you borrow against a life insurance policy?
Before you can take out a life insurance policy loan, you’ll need to build up sufficient cash value in your account, which can take several years. This is because your initial premiums will largely cover insurance agent commissions, and your subsequent scheduled premiums will partly go toward the life insurance coverage and administrative fees.
Key Takeaways
- A life insurance policy loan is a quick and easy way to get cash by borrowing money from your life insurance policy.
- Life insurance policy loans are secured by cash value, so they can only be taken out against permanent life insurance policies, such as whole life insurance and universal life insurance.
- The advantages of life insurance loans include a quick approval process, lower interest rates, and no credit check.
- Life insurance loans also come with risks, such as reduced death benefits and potential policy lapse if you fail to keep up with your payments.
- Alternatives to taking out a life insurance policy loan include selling your life insurance policy, opting for cash surrender value, and purchasing an accelerated death benefit rider.
If you’re thinking about taking out a life insurance loan, it’s a good idea to reach out to a financial advisor or other financial professional who can help you decide whether it’s the right option for you. Looking for a good life insurance policy that you can eventually cash out from? Start by researching how to find the best whole life insurance policy, then look for the best life insurance companies that can offer you the right policy for your needs!
BS
Bryce Sanders is president of Perceptive Business Solutions Inc. He provides HNW client acquisition training for the financial services industry. His book, “Captivating the Wealthy Investor” is available on Amazon. Bryce spent twenty years with a major financial services firm as a successful financial advisor. He has been published in 40+ metro market editions of American City Business Journals, Accountingweb, NAIFA’s Advisor Today, The Register, LifeHealthPro, Round the Table, the Financial Times site Financial Advisor IQ and Horsesmouth.com.
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