Borrowing Against Life Insurance: What Australians Need To Know

Life insurance serves as a financial safety net for loved ones, providing protection and peace of mind. But did you know that in Australia, you can borrow against your life insurance policy? This process, known as a policy loan, allows individuals to access the cash value accumulated within their life insurance policy. This option offers a valuable source of funds in times of need, providing financial flexibility. However, it's important to understand the implications and potential risks involved before making any decisions. In this paragraph, we will explore the key considerations regarding borrowing against life insurance in Australia, including the advantages, disadvantages, and the impact on death benefits.

Borrowing against permanent life insurance

In Australia, individuals can borrow against their life insurance policy through a policy loan. Policy loans allow access to a portion of the cash value that has built up within the policy. This provides financial flexibility, especially in times of need. There is no credit check or stringent loan approval process, and policy loans often come with lower interest rates compared to traditional loans. Additionally, policy loans offer flexibility in repayment, with no set schedule.

However, it is important to consider the impact on the death benefit. Borrowing against a life insurance policy will reduce the amount payable to beneficiaries. There is also a risk of policy lapse if the loan amount and interest exceed the cash value. Before making any decisions, it is advisable to consult with a financial advisor to fully understand the terms and conditions of policy loans.

While permanent life insurance offers the ability to borrow against the policy, term life insurance does not have this feature due to the absence of a cash value component. Term life insurance is designed to provide coverage for a limited period, usually ranging from one to 30 years, and is generally more affordable than permanent life insurance.

Whole life insurance

Common Features of Whole Life Insurance

• Lifelong protection, unless the policy is cancelled
• Level premiums that don’t increase with age
• A guaranteed death benefit
• Guaranteed earnings (at a certain rate) that will increase the cash value each year
• The possibility of dividend earnings, which can be withdrawn or used to increase the cash value of the policy or reduce premiums

Costs of Whole Life Insurance

The price of whole life insurance premiums is generally more expensive than other types of life insurance policies. A whole life policy can cost up to 15 times more than a term policy. Whole life premiums are generally based on the age, gender, smoking status, health, and lifestyle of the insured individual. The amount of life insurance cover chosen will also affect the premium payment.

History of Whole Life Insurance

Advantages of Whole Life Insurance

• Lifelong protection unless the policy is cancelled
• Level insurance premiums that don’t increase with age or circumstance, making budgeting easier
• A guaranteed death benefit payment
• The possibility of dividend earnings, which can be withdrawn and utilised as an income stream or invested back into the policy
• A portion of the premium paid is placed in a savings account, usually managed by the insurer, and grows at a guaranteed rate over time (cash value)
• The withdrawal clause in most policies enables the policyholder to take a part of the cash value or discontinue coverage in exchange for surrender charges
• Whole life insurance policies provide a guaranteed minimum payout regardless of the cover holder’s life expectancy

Disadvantages of Whole Life Insurance

The main disadvantages of whole life insurance include:

• Higher premium payments, which can be extremely expensive
• Complexity due to the cash value component, dividends, and other options, making them harder to understand compared to term life insurance
• Lower investment returns compared to other investment options like stocks or mutual funds
• Less flexibility, as policyholders are locked into the policy for life and may face penalties for cancelling

Universal life insurance

Unlike term life insurance, universal life insurance policies offer the flexibility to increase the cover amount when necessary without requiring additional medical evidence. Additionally, the death benefit in universal life insurance remains the same, regardless of the inflation rate, which may result in insufficient cover over time.

While universal life insurance provides lifelong protection and access to cash, it has some disadvantages. The premiums are typically much higher compared to term life insurance, and the policies are not flexible when it comes to increasing or decreasing the cover amount. The cover amount may not keep up with inflation, leading to potential underinsurance at the time of the claim. Furthermore, the interest earned on the cash value may be lower than other available investment options.

Tax implications of policy loans

Borrowing against your life insurance policy in Australia can be a valuable source of funds in times of need. However, it's essential to understand the tax implications of policy loans to make informed financial decisions. Here are some key considerations regarding the tax implications of policy loans:

No Immediate Tax Consequences

Policy loans are not typically considered taxable income. When you borrow against your life insurance policy, you are essentially borrowing from yourself, and the loan amount is secured by the cash value of your policy. Therefore, the loan is not treated as income by the Australian Taxation Office (ATO). This means that you don't have to include the loan amount as income on your tax return, and you won't owe taxes on it as long as the policy remains active.

Impact on Death Benefit

While policy loans are not taxed as income, they do have an impact on the death benefit payable to your beneficiaries. If the loan is not repaid by the time of your death, the outstanding loan amount, including any accrued interest, will be deducted from the death benefit. This means that your beneficiaries will receive a reduced payout. It's important to consider this long-term impact on your loved ones' financial security when deciding to take out a policy loan.

Policy Lapse Risk

If the loan amount, including any accumulated interest, exceeds the cash value of your policy, your policy may lapse. This means that your coverage will be terminated, and you will no longer have the protection provided by your life insurance policy. In this case, the loan amount may become taxable, and you could owe income taxes on the gains made through investments within your policy.

Interest Charges

Life insurance companies typically charge interest on policy loans. If you don't repay the interest charges, they will continue to accrue, increasing the total amount you owe. High interest charges can increase the risk of policy lapse, as they can cause the loan amount to exceed the cash value of your policy. It's important to carefully review the interest rates and terms associated with policy loans before making a decision.

Repayment Flexibility

Policy loans offer flexibility in repayment. You are not required to repay the loan on a fixed schedule, and there are generally no mandatory monthly payments. However, it's important to note that unpaid loans will reduce the death benefit for your beneficiaries. Additionally, if the loan amount and interest exceed the cash value, your policy may lapse, resulting in potential tax consequences.

Consulting Professionals

Before taking out a policy loan, it's advisable to consult with a financial advisor or tax professional. They can help you understand the specific tax implications based on your circumstances and ensure that you are making informed decisions about your life insurance policy and overall financial strategy.

Pros and cons of policy loans

Pros of Policy Loans

Policy loans can be a quick and easy way to get cash when you need it. They are available if you have a permanent life insurance policy with a cash value component. The cash value represents the savings component that grows over time as you pay your premiums. Here are some advantages of policy loans:

• No Credit Check: There is usually no need for a credit check or a stringent loan approval process since the loan is secured by the policy's cash value.
• Low-Interest Rates: Policy loans often have lower interest rates compared to traditional loans, making them a more attractive option for accessing funds.
• Flexible Repayment: Policy loans offer flexibility in repayment. There is no formal repayment timeline, and you can choose to repay the loan at your own pace or opt not to repay it at all.
• No Impact on Credit: Policy loans do not affect your credit score or history, unlike other types of loans.
• Quick Access to Funds: It doesn't take long to access the loan funds. Since there is no approval process, you can usually receive the funds within a week of requesting the loan.
• No Restrictions on Usage: You can use the loan funds for whatever you choose. The insurance company does not require you to explain or justify how you intend to use the money.
• Tax-Free: Policy loans are generally not considered taxable income. You can borrow your cash value without owing income tax, even on earnings above what you paid in premiums.

Cons of Policy Loans

While policy loans offer several benefits, there are also some important considerations and potential drawbacks:

• Reduced Death Benefit: If the loan is not repaid before the policyholder's death, the loan amount plus any accrued interest will be deducted from the death benefit paid to the beneficiaries. This could significantly impact the financial security of your loved ones.
• Interest Accrual: You will owe interest on the loan balance. If left unpaid, the interest will continue to accrue, increasing the total amount owed.
• Risk of Policy Lapse: If the loan amount and interest exceed the policy's cash value, your policy may lapse, resulting in the loss of coverage. This could leave you without insurance protection.
• Tax Implications: If the policy lapses due to an unpaid loan, you may owe income tax on the amount you borrowed. Additionally, if the loan is reclassified as a withdrawal, you may owe income tax on any amount received above your premium payments.
• Impact on Cash Value: Borrowing against your policy's cash value will reduce the available funds for investment growth. This could result in lower earnings over time.
• Additional Fees and Charges: The insurance company may charge various fees and expenses related to the policy loan, increasing the overall cost.

Frequently asked questions