Life Insurance: Business Loan Guarantor?

Life insurance is often a requirement for small business loans, especially when the business is closely connected to an individual or a few individuals. This is because, in the event of the owner's death, the business may no longer be able to operate. In such cases, life insurance acts as collateral, ensuring that the loan will be repaid. While this is not a scenario anyone wants to imagine, it's a reality in small business lending.

When is life insurance required for a business loan?

Whether or not life insurance is required for a business loan depends on several factors, including the type of loan, the size of the loan, the collateral available, and the lender's requirements. Here are some general guidelines:

SBA 7(a) Loan:

An SBA 7(a) loan typically requires life insurance for the full loan amount. However, if you have pledged significant personal or business assets as collateral, the life insurance requirement may be reduced or waived. The SBA 7(a) loan is the flagship product of the SBA loan program, offering loans up to $5 million for various business purposes.

SBA 504 Loan:

For an SBA 504 loan, life insurance is typically only required if your collateral doesn't fully cover the loan. In some cases, the property or equipment purchased with the loan may be sufficient collateral. The SBA 504 loan program provides financing for major fixed assets such as real estate and equipment.

Non-SBA Commercial Loan:

For a non-SBA commercial loan through a bank or other lending institution, the requirement for life insurance is solely at the discretion of the lender. Each lender has different policies and requirements regarding life insurance as collateral.

In general, life insurance for business loans is not always mandatory, but it can be beneficial. It protects the lender's interest by ensuring the loan will be repaid if the business owner passes away. Additionally, it safeguards the business owner's family or heirs from having to take on the outstanding debt. Life insurance can also demonstrate to the lender that the borrower is serious about their business and has a plan in place for unforeseen circumstances.

How does life insurance act as collateral for a business loan?

Life insurance can be used as collateral for a business loan, which is known as a collateral assignment. This is when a lender becomes the assignee of a life insurance policy, giving them a claim to some or all of the death benefit until the loan is repaid. This acts as a guarantee that the loan will be repaid if the borrower dies or defaults.

The process of using life insurance as collateral for a business loan typically involves the following steps:

Ownership of the Policy:

The borrower of the business loan must be the owner of the life insurance policy, but they may not be the insured person. This means that the borrower is responsible for paying the policy premiums and keeping the policy current for the duration of the loan.

Type of Life Insurance Policy:

The type of life insurance policy used for collateral can vary. Term life insurance and whole life insurance policies are commonly used. However, lenders may prefer a whole life insurance policy with an accrued cash value, as it provides a tangible asset that can be used as collateral.

Collateral Assignment Form:

The borrower will need to fill out a collateral assignment form provided by the insurer. This form must be completed by all parties involved, including the borrower, lender, and insurance company. The form designates the lender as the assignee of the policy until the loan is repaid.

Death Benefit as Collateral:

The death benefit of the life insurance policy serves as collateral for the loan. In the event that the insured person dies while the loan is still outstanding, the lender has the right to claim a portion of the death benefit equal to the outstanding loan balance. Any remaining proceeds are then paid to the beneficiary chosen by the policy owner.

Removal of Collateral Assignment:

Once the loan has been fully repaid, the collateral assignment is removed, and the lender is no longer the beneficiary of the death benefit. The borrower regains full ownership of the life insurance policy, and the lender provides documentation confirming the removal of the assignment.

It is important to note that using life insurance as collateral for a business loan has advantages and disadvantages. It can help business owners obtain the necessary financing for growth and expansion. At the same time, it also provides protection for the lender, ensuring that the loan will be repaid even in the event of the borrower's death. However, there is a risk of losing the life insurance policy if the borrower defaults on the loan, which could result in beneficiaries not receiving the intended death benefit.

What are the different types of life insurance that can be used as collateral?

When it comes to using life insurance as collateral for business loans, there are two main types: term life insurance and permanent life insurance.

Term Life Insurance

Term life insurance is the most popular policy purchased by self-employed people to cover their business loans. It offers a level death benefit with premiums guaranteed for between 10 and 30 years. By matching the term length to the amortization schedule of the business loan, the premiums payable can be minimized. Once the term insurance expires, the loan should be paid off, and no further life insurance coverage is needed.

However, term life insurance is not always accepted as collateral by lenders due to its lack of cash value.

Permanent Life Insurance

Permanent life insurance includes subcategories such as whole life, universal life, and variable life. These policies tend to be more expensive than term life insurance but are more appealing to lenders due to their cash value component. The cash value of these policies can be used as collateral for business loans, and the longer the premiums are paid, the more value the policy will build.

Universal Life Insurance

Universal life insurance is a type of permanent coverage that provides flexible premiums, death benefits, and cash values. It allows policyholders to design their insurance policy according to their preferences. While universal life insurance is typically expensive, it can be a good option for those seeking permanent coverage for life.

How much life insurance is required for a business loan?

The amount of life insurance required for a business loan depends on several factors, including the size of the loan, the type of loan, the collateral available, and the number of owners/partners in the business.

SBA Loans

The Small Business Administration (SBA) requires a life insurance policy to secure a small business loan when the business is closely connected to one or more individuals. In such cases, the lender must determine the viability of the business without a particular individual and, if the business is deemed dependent on that person, request life insurance.

For an SBA 7(a) loan, life insurance is typically required for the full loan amount. However, if you've pledged significant personal or business assets as collateral, the life insurance requirement may be reduced or waived. An SBA 504 loan usually only requires life insurance if your collateral doesn't fully cover the loan.

Non-SBA Commercial Loans

For non-SBA commercial loans through a bank, the requirement for life insurance is solely at the discretion of the lending institution.

Loan Amount and Type

Typically, the life insurance policy must be for the same amount and length of time as the loan. So, if the loan is for $500,000, the insurance must be for the same amount or more. If the loan term is 10 years, the insurance term must be at least 10 years.

Existing Policies

If you already have a life insurance policy, you may be able to assign part of your existing policy as collateral coverage, provided your insurer allows it. Otherwise, you may need to purchase a new policy.

What happens to the life insurance policy after the business loan is paid off?

When a business owner takes out a loan, they may be required to have life insurance, which acts as collateral. This ensures the loan will be repaid in the event of their death.

Once the loan has been paid off, the collateral assignment must be lifted from the policy. The lender will send a release form to the insurance company, which will then cancel the assignment and restore all rights in the policy to the owner. The owner can continue to make premium payments and the policy will remain in effect, but the lender will no longer have any rights to it.

The policy can then be used for other business planning needs, such as buy-sell agreement funding or key person protection.

Frequently asked questions