Introduction
Life insurance is mainly intended to give your loved ones financial protection in case of your premature death However most people do not know that some forms of life insurance policies enable them to borrow cash against the accumulated cash value over time This option referred to as a policy loan can be a great financial instrument during a time of need or when one is confronted with huge expenses
Borrowing against a life insurance policy has various advantages such as reduced interest rates and simpler approval than conventional loans Nevertheless it is vital to learn how policy loans function their benefits and drawbacks and the best means of utilizing them responsibly This guide will cover everything you need to know about borrowing against your life insurance policy
What Is a Policy Loan
A policy loan is a form of loan whereby policyholders borrow funds against the cash value of their life insurance policy as collateral Unlike bank loans or loans from financial institutions policy loans do not need a credit check income proof or collateral in addition to the policy The insurance company issues the loan and takes it against the cash value of the policy
Policy loans can only be offered to specific forms of life insurance like whole life and universal life These policies earn cash value as they mature that may be drawn down by the policyholder as a loan The maximum amount borrowed would usually rely on the policy’s cash value as well as the terms and conditions of the insurance company
Types of Life Insurance Policies That Allow Borrowing
Not all life insurance policies provide the option of taking a loan Generally only permanent life insurance policies offer this benefit while term life insurance policies do not
Whole Life Insurance
Whole life insurance is a form of permanent life insurance that covers the insureds entire lifetime provided premiums are paid It also has a savings feature called cash value which increases over time Policyholders can borrow against this accumulated cash value typically up to a percentage determined by the insurance company
Universal Life Insurance
Universal life insurance also accumulates cash value that can be borrowed against But since universal life policies are invested in the financial markets the cash value can vary making borrowing a bit more complicated than with whole life insurance
Variable Life Insurance
Variable life insurance policies permit policyholders to invest in stocks bonds and mutual funds The cash value of such policies is market-dependent Policy loans are available but can be riskier because of market fluctuations
Term Life Insurance Not Eligible
Term life insurance does not have cash value so it cannot be borrowed against in the form of policy loans Term policies cover the insured for a specified period such as 10 20 or 30 years and pay a death benefit only if the policyholder dies during the term
How Much Can You Borrow Against Your Life Insurance Policy
The level one can borrow is determined by the cash value of the policy and by the policies of the insurance company Usually insurers permit policyholders to borrow between 80 and 90 percent of the cash value accumulated However this differs from provider to provider
For instance if a policy has a cash value of 50000 the policyholder can borrow between 40000 and 45000 The loan does not decrease the cash value itself but is borrowed from the insurance company against the policy as collateral The outstanding loan balance earns interest which has to be paid back over time to avoid adverse effects like policy lapse
Benefits of Borrowing Against a Life Insurance Policy
Policy loans have a number of advantages that make them very appealing compared to other loans
No Credit Check Necessary
Because policy loans are collateralized by the life insurance policy’s cash value, no credit check is needed Thus, they serve as a lending option for someone with poor credit or who may not be qualified for conventional loans
Lower Interest Rates
Policy loans have lower interest rates than personal loans credit cards and payday loans The company sets the interest rate, and it is usually more reasonable than what banks or other lenders can offer
No Fixed Repayment Schedule
In contrast to the fixed monthly payment policy of traditional loans policy loans do not have a fixed repayment schedule Policyholders can pay the loan according to their own time provided the interest is not more than the amount of available cash value
Quick Access to Funds
Because the policyholder is taking the loan from their own policy the loan process is quicker than with standard lenders The majority of insurance companies handle policy loans in a matter of days which makes them an easy choice for unforeseen financial necessities
No Tax Implications if Managed Properly
Policy loans are not taxed as income as long as the policy is not lapsed This renders them an efficient tax option for accessing money
Risks and Disadvantages of Policy Loans
Even with their advantages policy loans have some risks that should be well weighed before borrowing
Interest Accumulation Can Lessen Policy Benefits
Policy loans collect interest over the years If left unpaid it goes on accumulating that can substantially depreciate the entire value of the policy and benefits
Risk of Policy Lapse
If the loan balance due plus interest outpaces the cash value of the policy the policy can lapse Which means the policyholder might entirely lose their life insurance coverage
Decreased Death Benefit
In case the loan is not paid back before death of the policyholder the outstanding amount is subtracted from the death benefit A lowered payout will thus be given to the beneficiaries posing a possible threat to their financial security
Possible Tax Obligations
If there is a policy that lapses while having an outstanding loan the amount of loan can be taxable under IRS regulations This can result in a surprise tax bill that policyholders should know about
How to Repay a Policy Loan
Although policy loans do not require fixed monthly payments it is advisable to repay them to avoid financial risks Here are some ways to manage policy loan repayment effectively
Make Partial or Full Payments
Policyholders can make partial payments over time or repay the full amount whenever possible This helps prevent excessive interest accumulation and ensures the policy remains in good standing
Utilize Policy Dividends if Applicable
Certain life insurance policies come with dividend payments that can be utilized to settle the loan Paying back the loan balance with dividends can lower the overall cost over the years
Make Regular Interest Payments
While it is not possible to repay the entire loan policyholders must at least settle the interest in order to keep the loan balance from escalating endlessly
Consider Refinancing
In the event that the loan balance proves to be a challenge to the policyholders they can consider refinancing from other financial institutions in order to pay off the policy loan
When Should You Consider Taking a Policy Loan
Policy loans can be useful in specific circumstances but one should use them judiciously Here are a few situations under which taking a policy loan will be a prudent decision
- Emergency money needs like home repairs or medical emergencies
- Investment opportunities for business where less interest borrowing is desirable
- Consolidation of debt to replace high interest with a lower interest policy loan
Conversely policyholders ought not to use a policy loan for discretionary items like vacations or luxury items purchases or speculative investment that may lack guaranteed returns
Alternatives to Policy Loans
If borrowing against a life insurance policy is not the best option consider these alternatives
- Personal loans from banks or credit unions which offer structured repayment terms
- Home equity loans which provide low interest borrowing for homeowners
- Retirement account loans such as borrowing from a 401k plan
- Credit cards for temporary emergency spending but with care considering high interest charges
Final Thoughts on Borrowing Against a Life Insurance Policy
A policy loan is a viable financial resource if handled sensibly It provides easy access to money with little approval process and lower interest rates compared to most other sources of borrowing However it also poses risks in the form of policy lapse diminished death benefits and possible tax implications
Prior to borrowing against a life insurance policy policyholders must critically assess their ability to repay take into account the effect on future benefits and seek other avenues of financing If managed prudently, a policy loan can afford temporary relief without compromising long-term security
