Using Life Insurance As Collateral: Is It Possible?

Life insurance can be used as collateral when applying for a loan, a process known as a collateral assignment. This involves using a life insurance policy as collateral for a loan or debt. The collateral assignment of life insurance is a common requirement for business loans, and lenders may even require you to get a life insurance policy to be used for collateral assignment. The collateral assignment of life insurance allows you to specify the amount of your death benefit that your lender receives if you pass away during your loan's term.

What is collateral assignment?

A collateral assignment of life insurance is a method of providing a lender with collateral when you apply for a loan. In this case, the collateral is your life insurance policy's face value, which could be used to pay back the amount you owe in case you die while in debt. It is a common requirement for business loans, and lenders may require you to get a life insurance policy to be used for collateral assignment.

Collateral assignment of life insurance allows you to specify the amount of your death benefit that your lender receives if you pass away during your loan's term. This allows your life insurance to serve as the collateral that many loans—especially small business loans or Small Business Administration (SBA) loans—require before they can lend you money.

If you die before fully repaying your loan, collateral assignment will allow the lender, or "assignee," to be repaid for the outstanding loan amount using your death benefit. If you pay back your loan fully before passing away, or if only a portion of your death benefit is needed to pay off your loan, your beneficiaries can still file a claim for the policy's death benefit.

Both term and permanent life insurance policies may be used as collateral, though some lenders may not accept term life policies since they don't have cash value. Using a cash value life insurance policy as collateral allows your lender to access the cash value, which provides an additional safeguard in case you default on your loan.

The borrower of a business loan using life insurance as collateral must be the policy owner, who may or may not be the insured. The collateral assignment helps you avoid naming a lender as a beneficiary.

What are the pros and cons?

Using life insurance as collateral for a loan is known as a collateral assignment. This allows you to put up your life insurance policy as collateral when applying for a loan, instead of using your house, car, or other assets. This can be a useful strategy for both the borrower and the lender, but it's important to consider the pros and cons before making a decision.

Pros:

• Lower interest rates: Loans secured with collateral often have lower interest rates than unsecured loans because lenders view them as less risky.
• Easier approval: If your life insurance policy has a sufficient cash value, securing a loan against it may be easier than obtaining an unsecured loan.
• Quick access to funds: Using life insurance as collateral can expedite the borrowing process, providing quicker access to loan funds compared to traditional loans.
• Preservation of investments: Using life insurance as collateral allows you to access funds without disrupting your investment portfolio or tying up other assets.
• Flexible repayment: Depending on the terms of the policy and loan agreement, borrowers may have flexibility in repaying the loan, such as using the cash value of the policy to pay down a portion of the loan.
• Personal and business use: Life insurance can be used as collateral for both personal loans and business loans, providing funding for various purposes.

Cons:

• Risk of losing the policy: If you default on the loan, the lender may have first claim to your policy's death benefit, potentially leaving your beneficiaries with nothing.
• Reduced death benefit: Borrowing against the cash value of a permanent life insurance policy can reduce the death benefit paid out to beneficiaries upon the policyholder's death.
• Limited duration: Term life insurance policies, which have a specific coverage period, may not align with the loan repayment terms, creating a risk for the lender if the policy expires before the loan is fully repaid.
• Potential for higher premiums: If you don't pay back the cash value taken from a permanent life insurance policy, it could result in higher premiums if you were using the invested returns to offset premium costs.
• Complexity and costs: Using life insurance as collateral can be complex, and it's important to understand the potential drawbacks and work with an experienced professional. There may also be additional costs involved, such as higher premiums or fees associated with the collateral assignment.

What types of life insurance can be used as collateral?

Life insurance can be used as collateral for a loan, which is known as a collateral assignment. The two main types of life insurance are term life insurance and permanent life insurance, and both can be used for collateral assignment.

Term life insurance is an insurance policy that is valid for a specific period. If you are using term life insurance as collateral, the policy's term length must be at least as long as the loan term. For example, if you have 20 years to pay off the loan, the term insurance must have a term of at least 20 years.

Permanent life insurance has various subcategories, including whole life insurance, universal life insurance, and variable life insurance, which can all be used as collateral. A permanent life insurance policy with a cash value is particularly appealing to lenders as they can access the cash reserves if needed.

When using life insurance as collateral, it is essential to understand the risks involved. If you default on the loan, the lender will have first claim to your policy's death benefit, which could reduce the amount that your beneficiaries will receive.

How do I take out a loan with a collateral assignment?

Yes, you can use life insurance as collateral when applying for a loan. This is called a collateral assignment of life insurance. It is a common requirement for business loans, but it can also be used for other types of loans, such as car loans or mortgages.

Step 1: Understand the Requirements

First, find out if your lender accepts collateral assignments of life insurance policies. Some lenders may require you to get a new life insurance policy for the collateral assignment, while others may accept an existing policy. If you need a new policy, shop around for one with a death benefit amount that meets the lender's requirements.

Step 2: Apply for Life Insurance

If you need to purchase a new life insurance policy, apply with an insurer. Once approved, confirm with your lender that the policy meets their requirements.

Step 3: Complete the Collateral Assignment Form

After paying your first life insurance premium, obtain a collateral assignment form from your insurer. On this form, you will need to provide your lender's contact information and add them as the death benefit collateral assignee until your loan is repaid. The form will also need to be signed by both you (the assignor) and the lender (the assignee).

Step 4: Proceed with Your Loan Application

Once your lender confirms that they are the collateral assignee for your life insurance policy, you can proceed with submitting your loan application.

Step 5: Maintain Your Life Insurance Policy

It is important to stay current on your life insurance premium payments and avoid cancelling your policy during the loan term. Failing to do so could violate your loan contract and give the lender the right to raise your loan's interest rate or demand full repayment.

Step 6: Understand the Impact on Your Beneficiaries

With a collateral assignment, you can still name beneficiaries as usual. However, the total death benefit available to them will depend on when you pay off your loan. If you pass away before repaying the loan, the lender will be entitled to a portion of the death benefit to cover the outstanding loan balance. Any remaining funds will then be distributed to your beneficiaries.

Step 7: Be Prepared When the Loan Ends

When you finish repaying the loan, the assignment terminates, and the lender no longer has a claim on your insurance policy. Ensure you receive documentation from the lender confirming this.

Using life insurance as collateral can be a worthwhile alternative to putting up your house, car, or other assets as security for a loan. It may also be a good option if you have a low credit score, as lenders may be more favourable to your loan application. However, it is important to understand the potential risks and drawbacks, such as the impact on your beneficiaries and the possibility of losing your life insurance policy if you default on the loan.

What are the alternatives?

There are several alternatives to using life insurance as collateral. Here are some options to consider:

Life Insurance Loan (Policy Loan)

If you have a permanent life insurance policy with a cash value, you can borrow against it. Policy loans are not taxed, and there are no credit or income checks. However, this option is not available if you don't already have a permanent life insurance policy, as it takes time to build up the cash value.

Surrender Your Policy

You can surrender your life insurance policy to access any cash value you have accumulated. However, doing so means your beneficiaries will no longer receive a death benefit.

Other Loan Types

You can explore other loan options that do not require life insurance as collateral. For example, you can apply for a personal loan or a home equity loan that uses your home equity as collateral.

Unsecured Loans

Depending on your credit score, you may be able to obtain an unsecured loan, such as a credit card or a personal loan, without needing to provide any collateral. Unsecured loans typically have higher interest rates than secured loans, but they don't put your assets at risk.

Home Equity Line of Credit (HELOC)

A HELOC is a flexible way to access funds without putting your life insurance policy at risk. With a HELOC, you can borrow against the equity in your home and only pay interest on the amount you borrow. However, it's important to remember that your home is at risk if you default on the loan.

It's always a good idea to consult with a financial advisor to discuss your specific situation and determine which alternative is the most suitable option for you. They can guide you through the pros and cons of each choice and help you make an informed decision.

Frequently asked questions