Life Insurance: Banks' Private Lending Requirements Explained

Life insurance is a crucial financial product that provides peace of mind and security for individuals and their loved ones. While the primary purpose of life insurance is to offer financial protection in the event of the policyholder's death, it can also serve other functions. One such function is the ability to borrow against the policy's cash value, which is typically associated with permanent life insurance policies like whole life or universal life. These policies accrue cash value over time, allowing policyholders to take out loans using this value as collateral. However, it's important to remember that borrowing against life insurance has its advantages and disadvantages, and it's not a requirement set by private lenders like banks.

Credit life insurance

One of the main goals of credit life insurance is to protect heirs from outstanding loan payments in the event of the borrower's death. It can also protect a co-signer on the loan from having to repay the debt. Credit life insurance can also be useful if you are unable to obtain regular life insurance due to health issues, as it usually does not require a medical exam.

It is important to note that credit life insurance is not always necessary and there are alternative options, such as increasing the amount of an existing life insurance policy or purchasing term life insurance. Additionally, it is against the law for lenders to require credit life insurance for a loan.

Borrowing from permanent life insurance

Permanent life insurance policies such as whole life insurance and universal life insurance are more expensive than term life insurance but 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 in a cash value account that's part of the policy. The purpose of the cash value is to offset the rising cost of insurance as you age, so premiums can remain level throughout life and not rise to unaffordable amounts in your later years.

Permanent life insurance has a few important values: the face value, the death benefit (often the same as the face value), and the cash value. One common misconception is that the cash value increases the death benefit. This is only true on certain types of permanent policies; on most policies, it does not increase the death benefit.

Money in the cash value grows at a rate that depends on the type of policy. For example, in a regular universal life policy, it grows based on current interest rates, while in a variable universal life policy, the cash value is invested by the owner in the stock market (and grows accordingly). It usually takes at least a few years for the cash value to build to sufficient levels to take out a loan.

Borrowing from your life insurance policy requires no credit checks or approvals, making it simple and hassle-free. However, if not paid off, interest will accumulate over time, and any unpaid loan balance, including interest, will reduce your policy's death benefit.

Keep an eye on your loan balance—if it exceeds your policy's cash value, your coverage will almost certainly lapse, leaving you without life insurance and a potential tax bill.

Here's a breakdown of the most common types of policies that let you borrow against your cash value:

• Whole life insurance: The slow and steady approach. Premiums gradually build cash value that you can borrow.
• Universal life insurance: Offers flexible premiums and cash value accumulation that you can tap into.
• Indexed universal life insurance: Ties your cash value to one or more stock market indexes, offering borrowing opportunities as it grows.
• Variable universal life insurance: A mix of flexibility and investment, with borrowing options as your cash value grows.
• Variable life insurance: Combines insurance with investment options, giving you the potential to borrow based on cash value growth.

Advantages of borrowing from your life insurance policy

Borrowing against your life insurance policy comes with some pretty unique perks. Not only does it give you access to funds when you need them, but it also offers flexibility that traditional loans just can't compete with. Here are some standout advantages that might make you think twice before heading to the bank:

• No red tape, just cash: Forget about long applications and approvals—with a life insurance loan, there's no credit check or invasive process. If your policy has enough cash value, you simply request the loan, and you're good to go. No stressful waiting, just fast access to the money you need.
• Your loan, your rules: Need funds for a surprise home repair or maybe a dream vacation? You can use the money however you like. And unlike traditional loans, you don't need to justify your spending to anyone. It's your policy, and how you use the cash is entirely up to you.
• Unseen and unheard: Unlike bank loans, life insurance loans fly completely under the radar. No need to worry about credit scores taking a hit because these loans aren't reported to credit agencies or the government. It's a completely private transaction between you and your insurer.
• Repayment? Only if you want to: With a life insurance loan, there's no pressure to pay it back right away. In fact, repayment isn't required during your lifetime. If you prefer, you can just pay the interest so the loan doesn't eat into your cash value. If you choose not to repay the loan, the outstanding balance will simply be deducted from the death benefit before your beneficiaries are paid.
• No risk to your assets: Unlike traditional loans where you might have to put your house or car on the line, borrowing from your life insurance policy only affects the policy itself. If you don't repay the loan, the worst that happens is a reduced death benefit—and in some cases, a tax bill—leaving you with no need to worry about losing your home or other assets.

Disadvantages of taking a loan out on life insurance

While borrowing from your life insurance policy has its perks, it's not without some serious caveats. Before you decide to tap into your policy's cash value, here are a few disadvantages to consider because not all that glitters is gold:

• Interest, the silent drainer: Just like any other loan, interest accumulates over time. If left unchecked, the interest could eventually drain your policy's cash value. And here's the kicker: if the cash value runs out, your policy could lapse, leaving you without coverage and potentially facing some hefty tax penalties.
• Bye-bye, cash value growth: Borrowing against your life insurance policy might slow down how quickly your cash value grows. Depending on the type of policy you have, taking out a loan will usually reduce the amount credited to your cash value or dividends, slowing down the steady accumulation you've been building. It's like taking one step forward and two steps back when it comes to growing that nest egg.
• Shrinking death benefit: One of the most significant downsides to borrowing from your policy is that it reduces the death benefit if the loan isn't repaid. The longer the loan lingers, the more it chips away at what

Borrowing from whole life insurance

Borrowing from a whole life insurance policy can be a quick and easy way to access cash. Unlike term life insurance, whole life insurance has a cash value independent of the death benefit, which you can borrow against. Borrowing from your life insurance policy requires no credit checks or approvals, making it simple and hassle-free.

However, it is important to remember that if you don't pay the loan back, it will be deducted from your death benefit. Additionally, if the cash value dips too low and the loan remains unpaid, your policy could lapse, leaving you without coverage and potentially a phantom income tax gain.

Advantages

• No red tape: There are no long applications or approvals, and there is no credit check or invasive process. If your policy has enough cash value, you simply request the loan and receive the funds within a few business days.
• Flexibility: You can use the money however you like, and you don't need to justify your spending to anyone.
• Privacy: Life insurance loans are not reported to credit agencies or the government, so they won't affect your credit score.
• No pressure to repay: There is no requirement to repay the loan during your lifetime. You can choose to only pay the interest so that the loan doesn't eat into your cash value.
• No risk to assets: Borrowing from your life insurance policy only affects the policy itself. If you don't repay the loan, the worst that happens is a reduced death benefit and, in some cases, a tax bill.

Disadvantages

• Interest accumulation: Interest accumulates over time and can eventually drain your policy's cash value. If the cash value runs out, your policy could lapse, resulting in a loss of coverage and potential tax penalties.
• Slowed cash value growth: Borrowing against your policy can slow down the growth of your cash value, reducing the amount credited or dividends.
• Reduced death benefit: Borrowing from your policy will reduce the death benefit for your beneficiaries if the loan isn't repaid.
• Rider reductions: Borrowing from your policy may reduce the amount available for special features, such as an accelerated death benefit rider.

Overall, while borrowing from a whole life insurance policy can provide financial flexibility, it is important to carefully consider the potential risks and long-term impacts on your coverage and benefits.

Borrowing from universal life insurance

Advantages

• No red tape: Borrowing from your life insurance policy does not require long applications, credit checks, or approvals. If your policy has sufficient cash value, you can simply request the loan and receive the funds within a few business days.
• Flexibility: There are no restrictions on how you use the borrowed funds. You can spend it on surprise home repairs, a dream vacation, or any other financial need without having to justify it to anyone.
• Privacy: Life insurance loans are not reported to credit agencies or the government, so they won't affect your credit score. It's a private transaction between you and your insurer.
• Relaxed repayment: There is no pressure to repay the loan right away. You can choose to only pay the interest or let the loan remain unpaid, and the outstanding balance will be deducted from the death benefit before your beneficiaries receive it.
• No risk to assets: Borrowing from your life insurance policy only affects the policy itself. Even if you don't repay the loan, the worst that can happen is a reduced death benefit and a potential tax bill.

Disadvantages

• Interest accumulation: Interest will accumulate over time, and if left unchecked, it can drain your policy's cash value. If the cash value runs out, your policy could lapse, leaving you without coverage and potentially facing tax penalties.
• Slowed cash value growth: Taking out a loan against your life insurance policy may slow down the growth of your cash value. This can impact the long-term accumulation of your nest egg.
• Reduced death benefit: Borrowing from your policy will reduce the death benefit if the loan isn't repaid. The longer the loan remains unpaid, the more it will decrease the financial security you leave to your loved ones.
• Rider reductions: Borrowing from your policy may reduce the amount available for special features, such as an accelerated death benefit rider, which allows early access to funds in cases of terminal illness.

Important Considerations

• Borrowing limits: Most insurers allow you to borrow up to 90% of your policy's cash value. It's important to monitor your loan balance to ensure it doesn't exceed the policy's cash value, as this could lead to a lapse in coverage and potential tax consequences.
• Interest rates: Interest rates on life insurance loans are typically lower than those for personal loans or credit cards, ranging from 5% to 8%. However, interest will accumulate over time, so it's important to factor this into your repayment plan.
• Tax implications: While life insurance loans are generally tax-free, if the loan is not repaid or the policy lapses, you may owe taxes on the borrowed amount. Consult a financial advisor to understand the tax implications before borrowing.

Lenders cannot require credit insurance

Federal law prohibits lenders from basing loan decisions on the acceptance of credit life insurance. Lenders also cannot require you to buy most types of credit insurance. However, some lenders may imply that credit insurance is necessary for you to get the loan, or they may automatically include it as part of the loan agreement. It is important to note that lenders can require credit property insurance on loans secured by a piece of property or possessions that could be destroyed, but they must give you the option to purchase insurance from a company of your choice.

If you realize after signing a loan contract that you have purchased credit insurance that you didn't want, you should be able to cancel it and receive a prorated refund. Before purchasing credit insurance, check to see if your homeowner's or life insurance policy already provides similar coverage. If you want additional protection for a large loan, a separate term life insurance policy for the same amount as the debt may be a better option.

Frequently asked questions