One of the biggest perks of having a life insurance policy is that you can borrow a loan against it. On the downside, you are only able to borrow against your life insurance policy if it is permanent. This is because permanent life insurance policies have a cash value component which is also the savings component, alongside the death benefit amount.
This cash value component is absent in temporary or term life insurance policies which only have a death benefit. Hence, they are usually cheaper when compared to permanent life insurance policies. Without a cash value component, you are not able to borrow against them and if you surrender such a policy, you wouldn’t receive any money from your insurer. You completely lose everything you have invested.
When you buy a permanent policy and start paying for the premiums, part of that amount goes into the death benefit while the rest makes up the cash value or savings component.
The value of the cash account grows at the policy’s set interest rates and is usually an amount equal to what you would be awarded should you surrender the policy at any point. So, when you borrow against your policy, you are borrowing from that cash value.
You can borrow from a permanent life insurance policy with a cash value component only when it reaches a specified amount, typically years after you start paying the policy premiums. This time is dictated by your insurer so it might vary from one life insurance company to the other.
Let’s dive into getting life insurance for a loan.
How it Works
As stated before, a life insurance policy loan is usually available where there is a cash value. And if you are taking out a loan against your policy, then the amount is usually a percentage of that cash value component. When applying for it, you need to first contact your insurer and find out the possible changes in the components of your policy after you borrow.
Ensure to ask for an in-force illustration that will help you understand the outcomes of taking the loan. This will demonstrate the policy loan depending on various factors such as repaying the loan, borrowing more money in the future, and retaining the loan. This should also reflect if the interest on the loan will be made from more borrowing or from out-of-pocket.
You will as well need to review other terms with your insurance company including how the interest will be charged. Mostly, the interest on policy loans is usually charged either in advance or in arrears.
When the interest is in advance, it is usually charged for the entire year. The assumption here is that the loan is kept on with for the whole of that policy year and if it is taken when the year has already begun, it is charged for the remaining part of the policy year from when the loan was borrowed. The insurer is not obligated to refund or provide any credit on any interest paid beforehand, should the loan be repaid in the course of the policy year.
Interest in arrears, on the other hand, is that which is charged at the end of the policy year such that the interest accumulates up until that time. So, interest accumulation begins whenever you take out a policy loan, even if it is in the middle of the policy year. As such, a loan repayment done in the middle of the year results in the decline of the amount of the interest. This means that the loan interest due at the end of the year decreases as well.
This interest will come with either fixed or variable rates, where the fixed rates are assured while the variable interests are subject to change. To this end, you are aware of the interest amount for the year from the get-go if the rates are fixed while with the variable interest rates, the premium notices of the due date of your loan interest alongside the variable interest rates are communicated when an annual statement of the policy is issued to you.
When you borrow against the cash value, that amount still gains interest, although lower than the one gained through the remaining cash value. But in some instances, these interest rates usually remain the same.
In order to establish the amount of interest credited to the borrowed cash value sum, the term “recognition” is used in whole life insurance policies. A direct recognition method could be used, and this translates to a low amount of dividends on the cash value component of the loan. However, you should expect the same dividend on your all cash value if the non-direct recognition approach is used.
An automatic premium loan provision is the other optional alternative, that automatically deducts the premium due from the cash value amount. Also, when taking out a policy loan, it is important to take note that overall, it is not tax-deductible. Ensure to go through everything important with your insurer before taking out a policy loan.
Taking Out a Life Insurance policy Loan
The process of taking out a life insurance loan is not as lengthy as you would think. It is very simple and you are usually required to fill out a form issued by your insurance company. Once you are done with the applications, you should get the amount you applied a loan for deposited to your account in just days.
During the application process, you might be required to confirm important personal details such as your identity, or signing a confirmation document. You might also be required to present a notarized confirmation before the loan is issued to you if there were recent changes in the ownership of the policy, if in the last month you gave new account information to the insurance company or if the loan exceeds a specified amount.
How Much You Can Borrow
The amount you can borrow from a life insurance policy will depend on your life insurance company. In most cases, the highest amount you can borrow is usually 90% of the cash value component, but there is no fixed least amount that one can borrow.
What it means is that to take out a loan on your policy is not using part of the cash value, rather using it as collateral after borrowing a loan. Hence, this is the reason why the cash value amount borrowed against continues to accumulate interest and remains as part of the life insurance policy.
Normally, loans work in that, the borrower is supposed to pay it back within a specific time frame. This is not the case with life insurance policy loans, because the cash value works as the collateral. On the downside, failure to pay the annual interest due, that payment is included in the outstanding loan amount. This translates to compounding interest especially if the loan lasts for a long time.
Additionally, the policy might lapse in the case where the outstanding loan reaches the cash value amount of the life insurance policy. If this happens, you completely lose your policy coverage and risk paying income taxes should the outstanding loan be more than what you paid for the premiums.
The bottom line is that, while you can comfortably borrow close to the full amount of your policy’s cash value, it could be risky and might cost you in the end. If you have to borrow against your policy, then ensure to be keen on the comparison between the loan amount and the cash value amount. And to be on the safe side, make sure your interest payments are always up-to-date.
Pros and Cons of Life Insurance for Loans
Without a doubt, borrowing against your life insurance policy has plenty of perks. From the interest rates to qualification, there are more advantages when compared to the latter. That said, the following is a quick rundown of the benefits of life insurance policy loans.
Your insurer will not inquire about how you intend to use the loan, like how banks normally do. So whether you want to take a vacation or you have a pressing financial problem that you need to sort out, no one will ask you. On the downside, interest starts to accrue and is added to the loan amount.
Low Interest Rates
Policy loans have lower interest rates when compared to other personal loans. This interest rate is usually between 6% to 8%.
Credit Check is not Necessary
Your insurance company will not need to do any credit checks before awarding you the loan. So, whether your credit history is good or bad, you will qualify for the loan. As long as your policy has accumulated a cash value, your creditworthiness will not prevent you from qualifying for a policy loan. The absence of qualifiers for the loan makes it the best solution whenever you need money quickly.
Loan Repayment is Not Fixed to a Specific Time
Another advantage of taking out a policy loan is that you can repay it when you want to. Heck, you don’t have to repay it if you don’t want to. Also, if the outstanding loan amount is less than the cash value of the policy, then you don’t need to make annual payments for the interest. This makes life insurance policy loans better than other forms of loans when you are not sure of when you will repay the loan.
While life insurance policy loans come with tons of advantages when compared to borrowing from lending institutions, a lot of individuals end up borrowing without much foresight. Hence, here are some of the cons of life insurance policy loans.
Decrease in Assets
While it is easy to qualify for a policy loan, it is equally risky. Borrowing against your life insurance policy reduces the number of assets you can use as collateral in the future. So, it is important to borrow against your life insurance policy only when you have an emergency.
Risk of the Policy Lapse
If the loan amount goes unrepaid and exceeds the cash value amount, then the policy may lapse and you risk possible termination from your insurer. Additionally, a lapse or surrender of the policy might result in taxation on the loan plus interest by the IRS.
Slow Increase of the Cash Value
You can only borrow against a life insurance policy after the cash value component builds up to a certain amount. During the early years of the policy, you might not be able to take out a loan since the cash value has not reached the required size. So, this could be a limitation if you want to take out a policy loan at the beginning of the life insurance policy.
A Decline in the Death Benefit
When you die before the loan balance is fully repaid, then your insurer pays out a lower death benefit to your beneficiaries. Any outstanding loan borrowed against the policy decreases the death benefit amount. So if your beneficiaries depended on the whole amount of the death benefit, then they might be left with a large financial gap considering that both the outstanding loan amount and the accrued interest are taken out before the death benefit is paid.
Is it a Good Idea?
There is a lot involved in borrowing against your life insurance policy, and while a lot of people take the whole process lightly, it is a serious issue. When you decide to take out a policy loan, understand that the interest rate grows at a high speed and might end up consuming the value of the entire life insurance policy.
Also, all permanent life insurance policies are different. Whole life, universal life, and variable life insurance policies carry the cash value component, but they all handle it differently. It is vital that you understand the stipulations of your policy before you take out a policy loan.
The only way to benefit from a policy loan is by repaying it as soon as you can. Allowing the loan amount to increase defeats the reason and importance of life insurance when the unpaid interest eats up the death benefit amount. Basically, before you borrow against your life insurance policy, set up a good repayment plan.
Alternatively, instead of borrowing against the life insurance policy, some policyholders prefer withdrawing part of the cash value sum. This has its downsides, and unlike borrowing against it which generates interest, it does not gain any interest and does not need to be repaid. Consequently, the death benefit permanently decreases. So, if you don’t intend to pay back your policy loan, then this could be a better option.
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.