Life Insurance: Borrowing From Your Policy

Borrowing from your life insurance policy can be a quick and easy way to get cash in hand when you need it. However, it is important to understand the risks involved. In this article, we will discuss how to get life insurance and the process of borrowing against your policy. We will also outline the pros and cons of policy loans, so you can make an informed decision about whether this type of loan is right for you.

Borrowing from permanent life insurance

Permanent life insurance policies, including whole life and universal life insurance, are more expensive than term life insurance but have no predetermined expiration date. If you pay sufficient premiums, the policy will remain in force for your lifetime. While the monthly premiums are higher than term life insurance, the 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.

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

The 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 a few years for the cash value to build to sufficient levels to take out a loan.

Unlike a bank loan or credit card, policy loans do not affect your credit score and there is no approval process or credit check since you are essentially borrowing from yourself. There is also no requirement to explain how you plan to use the money. The loan is also not recognised by the IRS as income and remains free from tax as long as the policy stays active. It is, however, expected that a policy loan will be paid back with interest, and there is no mandatory monthly payment.

A policy loan reduces your available cash value and death benefit. If you pass away while owing money on a life insurance loan, it will reduce the amount your beneficiaries receive.

Repaying the loan

Even with low interest rates and a flexible payback schedule, 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, you will likely owe taxes on the amount you borrowed.

Insurance companies generally provide many opportunities to keep the loan current and prevent lapsing. If the loan is not paid back before the insured person's death, the loan amount, plus any interest owed, is subtracted from the amount the beneficiaries are set to receive from the death benefit.

Potential pitfalls

There are several potential disadvantages to borrowing from your permanent life insurance policy:

• You reduce the death benefit: Taking money out of the life insurance policy while you are alive could reduce the survivor benefit.
• You tamper with the guarantee: Permanent insurance guarantees are based on certain assumptions, including that you will stick to your premium payments and accumulate cash at a certain level. If you take cash out, you may deplete the amount required to ensure the guarantee.
• You end up paying more money: Some permanent policies will ensure the guarantee when you take out cash, but at a cost that could force you to pay more in premiums to cover the difference.

Borrowing from whole life insurance

The process of borrowing against a whole life insurance policy is straightforward. You simply fill out a form and receive a payment, with no application process or credit check required. The funds from the loan go directly into your bank account, and you can use them for anything you want without having to provide an explanation to the insurance company. Additionally, the loan does not show up on your credit report and has a lower interest rate than bank loans or credit cards, typically ranging from 5% to 8%.

However, it is important to approach borrowing against a whole life insurance policy with caution. While there is no mandatory repayment schedule, failing to repay the loan can have consequences. If you don't pay back the loan, the death benefit will be reduced, and your beneficiaries will receive less money. Additionally, interest will continue to accrue on the loan balance, and if it exceeds the policy's cash value, the policy could lapse. In such cases, the entire loan amount could become taxable, resulting in unexpected costs.

To avoid these pitfalls, it is recommended to set a personal repayment schedule and stick to it. It is also crucial to consult a financial advisor before taking out a loan against your whole life insurance policy to ensure you understand the potential risks and rewards.

Borrowing from universal life insurance

Firstly, you can only borrow against a permanent life insurance policy, such as a whole life insurance or universal life insurance policy. These policies are more expensive than term life insurance but have no predetermined expiration date. If sufficient premiums are paid, the policy will be in force for the lifetime of the insured. While the monthly premiums are higher, money paid into the policy that exceeds the cost of insurance builds up a cash value account that is part of the policy. This cash value is used as collateral when you borrow against your life insurance policy.

It is important to note that it usually takes a few years for the cash value to build up to a level where you can borrow against it. The interest on the loan is typically much lower than on a bank loan or credit card, ranging from 5% to 8%. There is also no approval process or credit check, and the loan does not affect your credit score. You can use the money borrowed for anything you want, and there is no strict repayment schedule. However, it is important to pay back the loan in a timely manner, as interest accrues and can cause the loan to exceed the policy's cash value, leading to a policy lapse.

If the loan is not paid back before the insured person's death, the loan amount, plus any interest owed, will be subtracted from the death benefit paid to the beneficiaries. Additionally, if the policy lapses, you may owe taxes on the amount borrowed. Therefore, while borrowing from universal life insurance can be a convenient way to access cash, it is important to understand the potential risks involved.

Borrowing from variable life insurance

Variable life insurance is a type of permanent life insurance that includes a cash value component on top of the traditional death benefit portion. This cash value comes from a part of your premiums and is invested in a stock market fund managed by the insurance company or a company hired by them.

Variable life insurance policies include two components: a life insurance death benefit and a cash value account. The money from your insurance premium is used for account maintenance and fees, and some goes towards the death benefit. The rest of the money goes towards your policy's cash value, which functions as an investment account.

Here's how you can borrow from a variable life insurance policy:

Understand the Risks and Benefits

Variable life insurance policies offer both benefits and risks. On the one hand, they provide financial protection for your family, offer a potentially increased death benefit, and allow for flexibility and choice in investments. However, there are also potential downsides, such as high premiums, capped returns, and limited investment options.

Ensure Your Policy Has Sufficient Cash Value

Before borrowing against your variable life insurance policy, ensure that it has sufficient cash value. It usually takes a few years for the cash value to build up to a level where you can take out a loan. The minimum amount required varies by insurer.

Understand the Loan Terms

Variable life insurance policies typically allow you to borrow a portion of the policy's cash value without incurring surrender charges or paying federal taxes. However, these loans may reduce your policy's cash value and death benefit and increase the likelihood of policy lapse if not managed properly.

Be Mindful of Interest and Repayment

Interest rates on policy loans are typically much lower than on bank loans or credit cards, ranging from 5% to 8%. While there is no mandatory monthly payment, it is important to repay the loan in a timely manner to avoid accruing interest and potentially causing your policy to lapse.

Consult a Financial Professional

Before making any decisions, consider consulting a financial professional or advisor. They can help you understand the specifics of your policy, the potential tax implications, and whether borrowing from your variable life insurance is the right choice for your financial situation.

Borrowing from variable universal life insurance

Variable universal life insurance is a type of permanent life insurance policy that combines lifelong insurance protection with flexible premiums and a cash value component that can be invested in the market to produce greater returns. The cash value in a VUL policy is not guaranteed and can fluctuate based on market performance, providing both high growth potential and the risk of losses. Here are some key points to consider when borrowing from a VUL policy:

Understanding VUL

Variable universal life insurance is a complex product that offers both insurance protection and investment opportunities. It is similar to universal life insurance but provides more flexibility in terms of premium payments and investment choices. The cash value component of a VUL policy can be invested in various sub-accounts, similar to a brokerage account, offering the potential for higher returns compared to traditional universal life insurance.

Borrowing against your policy

One of the benefits of a VUL policy is the ability to borrow against the cash value. If you have accumulated sufficient cash value, you can use it as collateral to take out a loan from your insurance company. There is usually no approval process or credit check required, and you can use the loan for any purpose. However, it's important to note that unpaid loans may reduce your death benefit or cost you your policy.

Interest rates and repayment

Interest rates on life insurance loans are generally lower than those for personal loans or credit cards, typically ranging from 5% to 8%. While there is no strict repayment schedule, it is in your best interest to repay the loan as soon as possible to minimise interest accumulation. Failure to make regular payments and keep the loan amount below the policy's cash value may put your policy at risk of lapsing.

Tax implications

Life insurance loans are generally not considered taxable income as long as the policy remains active. However, if the loan is not repaid or the policy lapses, you may owe taxes on the borrowed amount. Additionally, if you withdraw funds from the cash value, any amount above the policy basis may be subject to taxes. It is always recommended to consult a financial advisor to understand the tax implications specific to your situation.

Impact on death benefit

It is important to understand that borrowing against your VUL policy will reduce the death benefit for your beneficiaries. If you pass away with an outstanding loan on your policy, the insurer will deduct the amount owed, including any accrued interest, from the death benefit. Therefore, it is crucial to weigh the benefits of borrowing against the potential reduction in the death benefit.

Managing risks

While VUL policies offer the potential for higher returns, they also carry risks. The cash value can fluctuate with market performance, and you may lose money if the market drops. Additionally, VUL policies often come with high fees and charges, which can impact your overall investment growth. It is important to carefully assess the risks and consider alternatives, such as universal life or whole life insurance, before purchasing a VUL policy.

Frequently asked questions