Borrowing From Life Insurance For College Tuition: Is It Possible?

Borrowing money from a life insurance policy can be a quick and easy way to get cash when you need it, such as for college tuition. However, it is important to understand the specifics of your policy and the potential risks involved before making a decision. Life insurance policies with a cash value component, typically found in whole life insurance plans, allow policyholders to borrow money against the value of the death benefit. This can provide a flexible source of funds with low-interest rates and no formal approval process or impact on your credit score. On the other hand, failure to repay the loan can result in a reduced death benefit for your beneficiaries and the risk of losing your coverage if the loan exceeds the policy's cash value. Understanding the pros and cons of borrowing against your life insurance policy is crucial before making any decisions.

Borrowing from permanent life insurance policies

Permanent life insurance policies are designed to provide coverage for your entire life, rather than for a fixed term. They also build cash value as you pay your premiums. This cash value can be used to take out a loan, with the value of the policy itself used as collateral to guarantee the loan will be paid back.

Permanent life insurance policies that allow you to borrow money include whole life, universal life, and final expense insurance. Term life insurance policies, on the other hand, do not have a cash value component, so you cannot borrow against them.

The amount of money you can borrow from a life insurance policy depends on how much cash value you have built up and the rules set by the insurer. However, policyholders can often borrow up to 90% of their cash value.

There are several advantages to borrowing from a permanent life insurance policy. There is no formal approval process, as the value of the plan is technically yours, and these loans will not affect your credit score. Additionally, life insurance policy loans often have lower interest rates than bank loans or credit cards, and there is no set repayment schedule.

However, there are also some disadvantages to consider. If you are unable to make monthly loan payments, you may lose your life insurance plan. If the loan is not paid back before the policyholder passes away, the beneficiary will only receive a reduced portion of the death benefit. And if the policy lapses, you may have to pay taxes on it since the tax structure will change.

It's important to carefully consider the pros and cons of borrowing from a permanent life insurance policy before making a decision.

Pros and cons of borrowing from life insurance

Borrowing from your life insurance policy can be a quick and easy way to get cash. However, it is important to understand the pros and cons before making a decision.

Pros of Borrowing from Life Insurance

• You can skip the lengthy loan application process.
• You can borrow without a credit check or questions from a lender.
• Policy loans don't show up on your credit report.
• You can repay the loan on your own schedule.
• You have the option of not repaying the loan, and instead, having it deducted from the policy's death benefit.
• Your policy's cash value continues to grow, even when you are using it as collateral for your loan.
• Interest rates on policy loans are often lower than those on comparable personal loans from banks or credit cards.
• You are protected from creditors for all the cash value locked up in your policy.

Cons of Borrowing from Life Insurance

• You may have to wait several years for the policy to build up a cash value.
• There is a risk of a reduced death benefit for your family if the loan isn't repaid while you are alive.
• There is a risk of losing your policy if the interest plus the unpaid loan amount exceeds the remaining cash value of the policy.
• If you take the cash value as a loan, there is no protection from creditors.
• If you take multiple loans over many years and the policy lapses, you may owe income tax on the borrowed amount that exceeds your premium payments.
• If you can't pay back the interest, you may want to reconsider borrowing.
• Borrowing the cash value reduces the available collateral for the loan, which reduces the dividends and generates less money to cover interest payments.
• There may be hidden costs that you don't initially realize.

How permanent life insurance works

Permanent life insurance is designed to provide coverage for the full lifetime of the insured person. It is more expensive than term insurance but combines a death benefit with a savings component that earns interest on a tax-deferred basis. The two primary types of permanent life insurance are whole life and universal life.

Permanent life insurance policies have much higher premiums than term life insurance policies, which lack a savings component. Permanent life insurance premiums cover the cost of the policy's death benefit and allow the policy to build cash value. The policy owner can borrow funds against that cash value through a policy loan or withdraw cash to help meet needs such as medical expenses or a child's college tuition fees.

The cash value of whole life insurance grows at a guaranteed rate, whereas universal life insurance features more flexible premium options and its earnings are based on market interest rates. Variable life and variable universal life provide expanded options to invest the cash value in mutual funds and other financial instruments.

Permanent life insurance policies enjoy favourable tax treatment. Cash value generally grows tax-free, meaning the policyholder pays no taxes on earnings as long as the money stays in the policy. Additionally, some money can be withdrawn from the policy without taxation, usually up to the total of the premiums paid.

However, taking out the policy's cash value will reduce the future death benefit for heirs. There is also a risk of the policy lapsing if the total unpaid interest on a policy loan, plus the outstanding loan balance, exceeds the amount of the policy's cash value.

Pros and cons of using life insurance for college

Borrowing from your life insurance policy can be a quick and easy way to get money to fund your child's college education. However, there are some pros and cons to consider before making a decision.

Pros of Using Life Insurance for College:

• Flexibility: Life insurance offers more flexibility than a 529 plan. If your child decides not to attend college, you can withdraw your earnings from a 529 plan, but they will be subject to income tax and a 10% tax penalty. With life insurance, you don't face the same tax consequences, and you have the option to use the funds for other purposes.
• Not included in financial aid calculations: Unlike a 529 plan, which is considered a parental asset, life insurance is not included in financial aid calculations. This means that it won't reduce your eligibility for certain types of student aid.
• No credit check required: Since you are borrowing against your own life insurance policy, there is no formal credit check required to qualify for a policy loan.
• Low-interest rates: Policy loans typically have lower interest rates compared to bank loans or credit cards. The interest rates for policy loans are usually between 0.25% and 2%, while the average interest rate for a two-year personal loan is 11.23%, and the average credit card interest rate is 20.40%.
• Flexible repayment: There is no formal repayment timeline for policy loans. You can repay the loan on your own schedule and at your own pace without any mandatory monthly payments.

Cons of Using Life Insurance for College:

• Reduced death benefit: If you don't repay the loan before the policyholder passes away, the death benefit will be reduced, and the beneficiary will only receive a portion of the original amount.
• Risk of lapse: If the loan amount plus interest exceeds the policy's cash value, the policy could lapse. This means that you would need to make additional premium payments to keep it in force.
• Tax consequences: If your policy lapses before the loan is fully repaid, you may owe income tax on the money you haven't paid back. You can recover your policy's "cost basis," which is usually the sum of premiums paid tax-free, but any amount received over this basis is subject to income tax.
• Upfront and recurring fees: Permanent life insurance policies often come with high upfront and recurring fees. For example, 50% or more of your first-year premiums may go towards paying the insurance representative's commission. Additionally, these policies typically charge upwards of 2% per year in administrative and investment costs.
• Time to build cash value: It can take a significant amount of time, often 10 years or more, for the cash value of your policy to surpass the amount you've paid in premiums. Therefore, it may not be a suitable option if you're looking to build up assets to pay for tuition in a short period.

Reasons to borrow from life insurance

Borrowing from your life insurance policy can be a quick and easy way to get cash for college tuition. Here are some reasons why borrowing from life insurance can be beneficial:

Flexibility

Life insurance offers greater flexibility compared to other savings plans like 529 plans. If your child decides not to attend college, you won't face the same tax penalties as you would with a 529 plan. With a life insurance policy, you have the option to use the funds for anything you need, providing a safety net for unexpected expenses.

No Impact on Financial Aid

The money in a life insurance policy is not considered an asset when applying for financial aid. In contrast, the funds in a 529 plan are counted as a parental asset, which can reduce eligibility for certain types of student aid. This makes life insurance a more attractive option for those who plan to apply for financial aid.

Low-Interest Rates

Policy loans typically have lower interest rates compared to bank loans or credit cards. The interest rates on policy loans are often much lower, ranging from 0.25% to 2%. This makes borrowing from your life insurance policy a more cost-effective option.

No Credit Check Required

Since you are essentially borrowing from yourself, there is no formal credit check required to qualify for a policy loan. This makes the process faster and more accessible, especially for those who may not have a strong credit history.

Cash Value Continues to Grow

When you take out a loan against your life insurance policy, the cash value continues to grow. The funds in your policy remain untouched, earning interest over time. This means that even while borrowing, your policy's value is still increasing, providing long-term benefits.

While there are advantages to borrowing from life insurance, it's important to carefully consider the potential drawbacks as well, such as high costs, complex withdrawal processes, and the risk of reducing the death benefit for your beneficiaries.

Frequently asked questions