Supplemental Life Insurance: Borrowing From Your Policy?

Supplemental life insurance is a common employee benefit that allows individuals to add extra coverage to their existing life insurance policies. This type of group insurance is typically offered by employers to enhance their basic group life insurance and is usually employee-paid. While it can provide several benefits, such as higher coverage limits and easy accessibility, there are also limitations to consider, including coverage ending upon leaving the job. One unique aspect of life insurance policies is the ability to borrow against their value under specific circumstances. Permanent life insurance policies, including whole, universal, and variable life insurance, often have a cash value component that grows over time. This cash value can be borrowed against, providing individuals with quick access to funds. However, it's important to understand the risks and implications, such as the potential loss of the life insurance plan and reduced death benefits if the loan isn't repaid.

Borrowing from permanent life insurance

Permanent life insurance policies, such as whole life or universal life insurance, offer a death benefit and a cash value component. The cash value grows over time, and policyholders can borrow against it. The application process is straightforward, and there are no income or credit checks. The loan amount typically cannot exceed 90% of the policy's cash value, and the funds are usually available within a few days.

Benefits of Borrowing from Permanent Life Insurance:

• No lengthy application or approval process: There are no credit checks or invasive procedures, making it a stress-free option.
• Flexible usage: The borrowed funds can be used for any purpose without justification.
• Privacy: Life insurance loans are not reported to credit agencies or the government, so they do not affect credit scores.
• Flexible repayment: There is no pressure to repay the loan immediately. Policyholders can choose to only pay the interest, and the outstanding balance will be deducted from the death benefit if unpaid.
• No risk to assets: Borrowing from a life insurance policy only affects the policy itself. Non-repayment will result in a reduced death benefit and, in some cases, tax consequences but will not put assets like a house or car at risk.

Risks and Drawbacks:

• Interest accumulation: Interest accrues on the loan, and if left unpaid, it can deplete the policy's cash value, leading to potential policy lapse and tax penalties.
• Reduced cash value growth: Taking out a loan may slow down the growth of the cash value, impacting the long-term accumulation.
• Decreased death benefit: The loan reduces the death benefit for the beneficiaries if not repaid.
• Rider reductions: Borrowing may decrease the availability of special features, such as an accelerated death benefit rider.

In conclusion, borrowing from permanent life insurance can be a convenient option for quick access to funds. However, it is important to carefully consider the benefits and drawbacks before making a decision. Understanding the potential risks and long-term implications is essential to ensure that short-term financial relief does not compromise future coverage and financial security.

Pros and cons of borrowing from life insurance

Borrowing from your life insurance policy can be a quick and easy way to get cash when you need it. However, there are some pros and cons to consider before making a decision.

Pros of Borrowing from Life Insurance

• There is no formal approval process or credit check required, since the value of the plan is technically yours.
• Life insurance loans are not recognised by the IRS as income, so you won't have to pay taxes on them.
• Life insurance loans will not affect your credit score.
• You can use the loan for anything you choose, and there are no restrictions on how you spend the money.
• You can borrow large amounts, typically up to 90% of your cash value.
• You can choose your own repayment schedule and there is no required monthly payment.

Cons of Borrowing from Life Insurance

• 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 policy owner passes away, the beneficiary will only receive a portion of the death benefit.
• If the life insurance policy lapses, you may have to pay taxes on it since the tax structure will change.
• You will owe interest on the loan, which can accumulate quickly if you are not making regular payments.
• Failing to repay the loan may result in losing your insurance coverage.

Types of permanent life insurance

Permanent life insurance policies are typically more expensive than term life insurance policies. However, they often offer extra advantages, such as a guaranteed minimum death benefit and the ability to accumulate cash value tax-deferred. Here is a detailed overview of the four types of permanent life insurance:

Whole Life Insurance

Whole life insurance is the most common type of permanent insurance policy. It offers a death benefit along with a savings account. Policyholders agree to pay a certain amount in premiums regularly for a specific death benefit. The savings element grows based on dividends paid by the company. Whole life insurance policies have fixed and guaranteed premiums, a rate of return on cash value, and a death benefit. The cash value component increases over time, based on the interest rate. Policyholders can withdraw funds or take out loans against the cash value. Whole life insurance policies are also \"participating,\" meaning they may receive dividends that can be used to pay premiums, add to the cash value, or increase the death benefit.

Universal Life Insurance

Universal life insurance offers more flexibility than whole life insurance. Policyholders may be able to increase the death benefit by passing a medical examination. It combines death protection with a savings account that can be invested in stocks, bonds, and money market mutual funds. The savings vehicle, called a cash value account, generally earns a money market rate of interest. Policyholders can alter their premium payments as long as there is enough money in their account to cover the costs. Universal life insurance policies have flexible premiums within certain limits. Once enough cash value has accumulated in the policy, policyholders can adjust their premium payments. Universal life insurance is less expensive than whole life insurance but more expensive than term life insurance.

Variable Universal Life Insurance

Variable universal life insurance is a category of universal life insurance that offers the flexibility of making variable premiums and choosing from various investment subaccounts for potentially greater cash value. This type of policy offers the greatest upside potential but also the most downside potential, as cash value is based on the performance of the investment subaccounts. Variable universal life insurance policies have flexible premiums and a savings component, but more factors influence how the savings can grow. The savings portion, or cash value, grows based on the investment methods chosen by the policyholder. There is usually a minimum and maximum growth rate allowed in this type of permanent life insurance policy.

Indexed Universal Life Insurance

Indexed universal life insurance is similar to universal life insurance but provides the added benefit of linking interest credited to the policy to an external index, such as the S&P 500. This interest crediting is typically subject to an upside "cap" and downside "floor." Due to the higher upside potential, premiums may be lower than those of universal life insurance, but they come with additional downside risk. The second type of universal life insurance is indexed universal life insurance, where the cash value grows based on a chosen stock market index. If the chosen index performs well, the account will grow; otherwise, some companies allow it to grow at a minimum rate.

How to borrow from life insurance

Borrowing from your life insurance policy can be a quick and easy way to get cash in hand when you need it. However, there are a few specifics to know before borrowing.

Types of Life Insurance Policies

Firstly, you can only borrow against a permanent life insurance policy, meaning either a whole life insurance or universal life insurance policy. Term life insurance, which is cheaper and more suitable for many, does not have a cash value and is designed to last for a limited period, generally anywhere from one to 30 years.

How to Borrow from Your Life Insurance Policy

If you have permanent life insurance, you may be able to use your policy's cash value as collateral to take out a loan. There is no approval process or credit check, and you can request a loan from your life insurance company for any reason. The only requirement is that you have sufficient cash value to borrow against (the minimum amount varies by insurer).

Interest and Repayment

Insurance companies will charge interest on the loan monthly, and you can either pay it as it comes in or let it accrue and pay it all later. It's important to pay the loan back in a timely manner—on top of your regular premium payments. If unpaid, interest is added to the balance and accrues, putting your loan at risk of exceeding the policy's cash value and causing your policy to lapse. If that happens, it's likely you'll owe taxes on the amount you borrowed.

Pros and Cons

Borrowing from your life insurance policy can be beneficial if you need cash quickly, don't want to use other assets as collateral, or want a flexible repayment schedule. However, there are also disadvantages to consider. Borrowing against your life insurance policy might slow down how quickly your cash value grows, and it could reduce the death benefit if the loan isn't repaid. Additionally, if the cash value dips too low and the loan remains unpaid, your policy could lapse, leaving you without coverage and potentially facing tax penalties.

Alternatives to borrowing from life insurance

Borrowing against your life insurance policy can be a quick and easy way to get cash in hand when you need it. However, it is not without its risks. If you are looking for alternatives to borrowing from your life insurance, here are a few options to consider:

Insurance Riders

Insurance riders are add-ons to your existing life insurance policy that enhance or adjust the coverage. For example, a long-term care rider might allow you to access your death benefit early for care-related expenses. A critical illness rider can provide access to your death benefit if you are diagnosed with a specific critical illness, such as cancer or a heart attack. These riders are versatile and can cater to various needs, but they usually come with a cost.

Increase Your Current Coverage

Instead of taking out a loan against your life insurance, you could consider increasing your existing policy's death benefit. This option often requires a review of your current health and circumstances but can be more straightforward than buying a new policy.

Ladder Term Life Insurance Policies

Laddering life insurance involves purchasing multiple term policies with varying durations and coverage amounts. As each term expires, your coverage will decrease, matching your changing life insurance needs over time. This can help you get cost-effective coverage without buying a single, larger policy.

Traditional Loans

Although it may be a more lengthy and complex process, taking out a traditional loan from a bank or credit card company is another option. This may be a good choice if you want to avoid putting your life insurance policy at risk or if you don't have sufficient cash value built up in your policy to borrow against.

Other Assets

If you are comfortable using other assets as collateral, you could consider taking out a loan against your house or car. This option may provide you with a larger loan amount and could have more favourable terms than a life insurance loan.

Frequently asked questions