Life Insurance Loans: How Do Uk Policies Work?

Life insurance loans are a quick and easy way to get cash when you need it. They are available to those with permanent life insurance policies, such as whole life and universal life, which have a cash value component. You can borrow up to 90% of the policy's cash value, and the loan is pretty much risk-free as there is no credit check, no approval process, and no impact on your credit score. However, it's important to remember that if you don't repay the loan, it will reduce the death benefit and may even cause your policy to lapse.

Borrowing from a life insurance policy

Term life insurance, on the other hand, does not have a cash value and is thus not eligible for borrowing. It is generally cheaper and suitable for many people, lasting for a limited period, typically between one and 30 years. However, in some cases, a term life policy can be converted into a permanent policy, allowing cash value to build up.

When borrowing from a life insurance policy, it is important to understand the risks involved. Policy loans reduce the death benefit if not paid off, and interest is added to the loan balance by the insurance company, which can cause the policy to lapse if left unpaid. Additionally, only permanent life insurance builds up cash value over time.

The process of borrowing from a life insurance policy is straightforward. First, you need to accrue enough cash value in your policy, which can take several years. Then, you request the loan from your insurer, specifying the amount you wish to borrow. The insurance company will then lend you the money, using the cash value of your policy as collateral. There are typically no restrictions on how you can use the funds.

Repaying a life insurance loan is crucial to avoid negative consequences. While life insurance loans do not have a fixed repayment schedule, it is advisable to repay them as soon as possible to minimise the accrual of interest. If the loan balance exceeds the remaining cash value of the policy, it may lapse, resulting in a loss of coverage. Furthermore, if the loan is not fully repaid before the insured person's death, the outstanding balance, including any interest owed, will be deducted from the death benefit paid to the beneficiaries.

Direct and indirect loans

Direct recognition and indirect recognition are methods used by insurance companies to determine how policy loans affect your whole life insurance policy's dividends.

Direct Recognition

Direct recognition is a method used by insurance companies to adjust the dividends paid on a whole life insurance policy when the policyholder has taken out a loan against the cash value. Under direct recognition, the insurance company will apply a lower dividend rate to the portion of the cash value that has been loaned, while the portion not used as collateral for the loan will continue to receive the full dividend rate. The main idea behind direct recognition is that the insurance company is compensating for the lost investment opportunity resulting from the loan by paying lower dividends.

Indirect Recognition

Indirect recognition, on the other hand, does not adjust the dividend rate based on policy loans. Instead, the insurance company continues to pay the same dividend rate on the entire cash value, regardless of whether a loan has been taken out. While the dividend rate remains unchanged, the insurance company still charges interest on the policy loan. The interest charged on the loan typically offsets the additional dividends paid, resulting in a more balanced financial outcome for both the policyholder and the insurance company.

How Direct and Indirect Recognition Affect Your Whole Life Insurance Policy

The primary difference between direct and indirect recognition lies in how they impact the performance of your whole life insurance policy. With direct recognition, the dividend rate adjustment may result in a lower overall return on your cash value if you take out a policy loan. Conversely, with indirect recognition, the dividend rate remains consistent, regardless of whether you have a loan, potentially leading to higher overall returns.

However, it is essential to remember that the performance of your policy will also depend on other factors, such as the financial strength and investment performance of the insurance company. When it comes to policy loans, indirect recognition offers more flexibility, as the dividend rate remains unchanged even when you take out a loan. This makes indirect recognition a more attractive option for those who plan on utilising policy loans as part of their financial strategy. Direct recognition may be more suitable for policyholders who do not plan on taking out loans or who prefer the stability of a guaranteed dividend rate for the unloaned portion of their cash value.

Pros and cons of borrowing against 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, there are several pros and cons to consider before making a decision.

Pros

• No credit check required: Since you are borrowing from your own policy, there is no formal credit check needed to qualify for a policy loan.
• Low-interest rate: Policy loans are a low-interest financing option, with interest rates ranging between about 5% to 8%, or even as low as 0% in some cases.
• Flexible repayment terms: There is no formal repayment timeline, so you can make payments as it suits your budget and cash flow.
• Cash value keeps growing: Your policy's cash value serves as collateral, so the funds continue to sit in your policy and gain interest.

Cons

• Minimum cash value required: You need to have sufficient cash value in your policy before you can take out a loan, which can take several years.
• Borrowing amount limited: You can typically borrow up to 90% of your cash value, so you may need to explore other financing options if you need to borrow more.
• Reduced death benefit: If you don't repay the loan before you die, it will be deducted from your beneficiary's death benefit.
• Risk of lapse: Interest will continue to accrue on the loan, and if the balance grows past the policy's cash value, the policy could lapse and you may lose coverage.

Repaying a life insurance loan

Typically, when you borrow against your life insurance policy, the outstanding loan amount will accrue interest over time. The interest rate may vary depending on the insurer and the terms of your policy. It’s essential to carefully review these details before making any decisions.

Repayment options for a life insurance loan can differ based on the specific terms of your policy. One common method is through regular premium payments that include both principal and interest. This allows you to gradually pay off the loan over time while maintaining coverage.

Another option is to make periodic repayments solely towards the interest accrued on the loan. With this approach, it’s important to keep in mind that the principal amount borrowed remains unchanged until fully repaid or settled differently.

If not managed properly, failing to repay a life insurance loan can have consequences such as reducing or completely eradicating death benefit payouts upon passing away. So it’s crucial to always be diligent about making timely repayments according to the agreement with your insurer.

Understanding how to pay back a life insurance loan can help ensure that you make informed financial decisions and maintain control over your policy coverage. Always consult with an experienced financial advisor who specialises in life insurance policies before making any borrowing commitments.

Tax implications of a life insurance loan

If you take out a loan against your life insurance policy, you generally won't have to pay income taxes as long as the policy remains in force. However, you could potentially face a tax bill if you surrender your policy or if the policy lapses, and the amount you owe exceeds what you paid in. In this case, you would have to pay income tax on any earnings from the investment.

A life insurance policy loan is not taxable as income, as long as it doesn't exceed the amount paid in premiums for the policy and the policy remains in effect. If you surrender your policy or your policy lapses, you must pay taxes on the money that came from interest or investment gains, even if you have an outstanding loan.

Repaying a loan from your life insurance cash value isn't mandatory, but outstanding debt will be deducted from the death benefit. If you don't repay your loan before you die, it will be deducted from your beneficiary's death benefit.

How much of a life insurance loan is taxable? You can take out a loan on a permanent insurance policy, like a whole or universal policy, that has a cash value. The money you borrow isn't taxable, as long as it's equal to or less than the sum of the insurance premiums you have paid.

However, keep in mind that life insurance companies add interest to the loan. If you don't repay the interest charges, your policy could lapse. A taxable amount equals the amount of the gain realised, which is any amount you received from the cash value of your policy minus the net premium cost, or the total of premiums paid minus distributions received. It is essentially the gains on the investments.

For example, let's say you've paid £40,000 in premiums and the cash value of your policy is £55,000. That means that £15,000 would represent the investment gains and would be subject to taxation if you surrendered the policy and took the cash value.

If you had an outstanding loan on the policy of £20,000, you would receive a reduced cash value of £35,000 but you would owe tax on the £15,000 in investment gains.

These same rules apply to a policy that lapses with an outstanding loan.

Other Considerations for Life Insurance Loans

Getting a life insurance loan is usually fairly easy and straightforward. You don’t have to go through an approval process because you are borrowing against your own assets. You can use the funds in any way you wish. Finally, you don’t have a repayment schedule or repayment date. In fact, you don’t have to repay a life insurance loan back at all.

However, if the loan isn't paid back before the insured person's death, the insurance company will reduce the face amount of the insurance policy by what is still owed when the death benefit is paid. In other words, the beneficiaries will receive less.

If a policy loan isn’t repaid, and unpaid loan and its interest can significantly cut into the death benefit, which can put the policy at risk of not providing enough money to beneficiaries.

If you do pay back all or a portion of the loan, your repayment options include periodic payments of principal with annual payments of interest, paying annual interest only, or deducting interest from the cash value. Consider making the minimum interest payments so the policy loan doesn't grow.

In a worst-case scenario, if added interest increases the loan value beyond the cash value of your insurance, your life insurance policy could lapse and be terminated by the insurance company. In such a case, you would owe income taxes on the overall gain in investments in your policy, regardless of the amount of loan you have.

Frequently asked questions