Life Insurance Loans: Borrowing Against Your Policy

Life insurance loans are a quick and easy way to get cash, but they come with certain risks. If you have a permanent life insurance policy that has accumulated cash value, you can borrow money from the insurer, using the cash value as collateral. However, this option is usually only available once your life insurance policy's cash value has reached a specific size, which may take five to ten years. Term life insurance policies, which are cheaper and more suitable for many people, do not have a cash value and therefore you cannot borrow against them.

Borrowing from permanent life insurance

Permanent life insurance policies such as whole life insurance or universal life insurance are more expensive than term life insurance, but they have no predetermined expiration date. If sufficient premiums are paid, the policy is in force for the lifetime of the insured. While the monthly premiums are higher than term life insurance, money paid into the policy that exceeds the cost of insurance builds up a cash value that is part of the policy. This cash value can be borrowed against.

The cash value of a permanent life insurance policy is an asset that you can borrow against, and life insurance policy loans are typically easier to get than a bank loan. Plus, you don't have to tell the lender what you want to do with the money. The application process is relatively easy, and there is no income or credit check. The money may be deposited into your account within a few days.

Each life insurance company sets its own rules about how much money can be borrowed from a policy, but it is usually possible to get a policy loan for up to 90% of the value in the policy. There is no set repayment period, but if you pass away before repaying, any outstanding loan balance will typically be deducted from your death benefit.

The loan funds do not come out of your policy but are instead lent by the insurance company using your policy as collateral. Since the money stays in your policy, it continues to earn interest and grow tax-favoured. However, you are charged interest on the loan, and if you do not repay the annual interest, it will be added to your loan amount.

If you decide not to repay the loan, the outstanding balance will be deducted from your death benefit, and if the total loan balance grows to be larger than your cash value, the policy could lapse. When your policy lapses, the cash you took out may be treated as income, and you could owe taxes on it.

Pros and cons of life insurance loans

Pros of Life Insurance Loans

You can skip the lengthy loan application process: There is no approval process, credit check, or income verification.

No credit check required: Since you are borrowing your own money, no formal credit check is needed to qualify for a policy loan.

Quick access to funds: Getting a life insurance policy loan is quick and easy.

You can use the loan funds for whatever you choose: Because your policy's cash value acts as collateral for the loan, you can use the money for anything from household bills to a vacation.

Loans do not have to be paid back: There is no required monthly payment for a policy loan and no payback date.

Money from an insurance policy loan is not taxed as income: Policy loans are not considered taxable income.

Cons of Life Insurance Loans

The death benefit will decrease if the loan isn't repaid: If you were to die before paying back your policy loan, the loan balance plus the interest accrued is subtracted from the death benefit that would be given to your beneficiaries.

You will owe interest on the loan: Between the time you take out the loan and the time you repay it, the insurance company will charge you interest on the outstanding balance.

Failing to repay your loan may result in losing insurance coverage: If the loan balance increases above the amount of the cash value, your policy could lapse and risk termination by the insurance company.

How to take out a life insurance loan

Taking out a loan 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.

Requirements

First, you need to have a policy with a cash value, which is a feature usually found in permanent life insurance policies (such as universal or whole life insurance). Term life insurance, which is the type typically provided by an employer, does not have a cash value.

Another requirement is to have enough cash value in your policy to use as collateral for the loan. Minimum amounts vary by insurance company, but it can take several years to build enough value to borrow against.

How to Apply

If you have the right policy with enough cash value, you can request a loan. Unlike traditional forms of financing, policy loans don't require a credit check or employer and income verification. You also don't need to specify the reason for taking out the money.

Some life insurance providers allow you to apply online, while others may require that you fill out a paper form. If you can't find any information on how to kick off the process, give your insurer a call. You might even complete the loan request over the phone, depending on your insurance provider's policies.

How it Works

When you borrow against your life insurance policy, you're essentially borrowing from the insurer using your policy's cash value and death benefit as collateral. Since the loan is secured, the interest rate is usually lower than on traditional personal loans or credit cards. The payment schedule is flexible, and you can typically extend repayment for as long as you need.

If you pay off the policy loan in full, the value of your policy will stay intact. However, if you pass away before you finish repayment, the balance amount plus any interest you owe could be subtracted from the death benefit, depending on your loan's particulars. This means your beneficiaries will receive less money.

Pros and Cons

A life insurance policy loan gives you access to cash without having to go through a credit check or even give a reason for why you need the money. Considering you can get lower interest rates than you would with most personal loans, the solution can seem appealing. But you should be aware of certain risks as well.

Pros

• It's simple to borrow provided you have enough cash value, and there's no credit or income check involved.
• You can get excellent terms such as a comparatively low interest rate and no strict repayment schedule.
• It's a tax-free financing source unless you terminate the policy or end up with a loan balance higher than the cash value of your policy.

Cons

• The cash value of your policy drops while you're repaying the loan. If you die before it's paid off in full, your beneficiaries won't receive the full death benefit.
• You could end up with a lapse in coverage if interest accumulates to the point where the outstanding balance exceeds the cash value of your policy.
• You could end up owing income tax on the loan amount if the balance exceeds your policy's cash value.

Risks of borrowing against life insurance

Borrowing against your life insurance policy can be risky. Here are some of the dangers:

Reduced Death Benefit

If you don't repay the loan before you die, the amount your beneficiaries receive will be reduced by the outstanding loan balance and any interest owed. This could significantly impact your loved ones' financial security.

Lapse in Coverage

If the interest on your loan accumulates to the point where the outstanding balance exceeds the cash value of your policy, it could lapse. This means you would lose your coverage and may also owe income tax on the loan amount.

Tax Consequences

If your policy lapses before the loan is fully repaid, you could owe income tax on the money you haven't paid back. You'll be able to recover your policy's "cost basis" (usually the sum of premiums paid tax-free), but anything over this amount is subject to income tax.

Lower Cash Value

The cash value of your policy will drop while you're repaying the loan. This could affect your ability to borrow against the policy in the future or to cover premiums.

Higher Premiums

Some permanent policies will guarantee the death benefit even if you take out a loan, but this could force you to pay higher premiums to cover the difference.

Interest Accumulation

Interest on the loan will continue to accrue, even if you're not making payments. This could cause the loan amount to exceed the policy's cash value, leading to a lapse in coverage and potential tax consequences.

Impact on Dividends and Interest

Taking out a loan against your policy may reduce the amount of dividends or interest you receive. This could slow down the growth of your cash value over time.

Alternatives to life insurance loans

Life insurance is a financial tool that provides for loved ones when you pass away. However, you may be declined for life insurance due to age, chronic illness, diabetes, a hazardous career, a history of cancer, or low income. Here are some alternatives to consider:

• Income protection insurance: This provides monthly, tax-free income if you are unable to work for a prolonged period due to illness or injury. It's available in terms of 12-60 months and pays between 50%-70% of your earnings.
• Guaranteed coverage plan: This form of insurance does not require a medical exam or records. You'll generally be eligible for coverage unless you exceed the age limit, typically between 50-80 years old. However, it can have high premiums, and the death benefit is usually capped at around $25,000.
• Critical illness insurance: This provides a tax-free lump sum if you develop a life-threatening illness. Coverage amounts vary but are typically between $5,000 and $75,000, depending on the premiums.
• Accidental Death and Dismemberment (AD&D) insurance: This covers fatal accidents or the accidental loss of a limb. This type of insurance does not consider your medical history or lifestyle choices, which may allow you to get coverage even if you'd otherwise be disqualified for life insurance.
• Mortgage protection insurance: This pays off the remaining balance of your mortgage if you pass away or are unable to work due to a disability. The payout covers the mortgage principal and interest but goes directly to the mortgage lender, leaving nothing for loved ones.
• Pre-paid funeral plan: This covers most or all of the expenses associated with a funeral, so beneficiaries don't have to worry about these costs. The median cost of a funeral is $8,300 and is often paid for using life insurance, but a pre-paid funeral plan can serve the same purpose.
• Asset-based long-term care insurance: This hybrid form of insurance combines long-term care coverage with an investment component. The investment component generally involves investing premiums into a fixed or variable annuity, which builds cash value over time.
• Employer-issued insurance: Some employers offer insurance as an optional benefit for employees. They may provide a minimum amount of coverage at no cost, but it can be increased if desired.
• Self-funded savings: If you're not eligible for insurance or don't wish to maintain coverage, you can create your own savings to provide for loved ones upon your passing. This could involve putting money into a savings account or reallocating your portfolio to maximize interest.

Frequently asked questions