Borrowing From Life Insurance: Is It Worth The Risk?

Borrowing from your life insurance policy can be a quick and easy way to get cash when you need it. However, there are some important considerations to keep in mind before making a decision. Firstly, it's essential to understand that you can only borrow against a permanent life insurance policy, such as whole life or universal life insurance, which has a cash value component. Term life insurance, typically provided by employers, does not have this feature.

When borrowing against your life insurance, you're essentially using the policy's cash value and death benefit as collateral with the insurer. This type of loan usually offers lower interest rates compared to traditional personal loans or credit cards, and there is no strict repayment schedule. However, if the loan isn't repaid before your death, the outstanding amount and interest will be deducted from the death benefit, reducing the amount your beneficiaries receive.

While life insurance policy loans offer advantages, they also come with certain risks. The cash value of your policy decreases during the repayment period, and if you pass away before full repayment, your beneficiaries will receive a lower death benefit. Additionally, there is a risk of a lapse in coverage if the interest accumulates and the outstanding balance exceeds the policy's cash value. Furthermore, you may owe income tax on the loan amount if the balance surpasses the policy's cash value or if the policy lapses before full repayment.

Borrowing from permanent life insurance

You can borrow against a whole life insurance policy or a universal life insurance policy. This is because only permanent life insurance policies build cash value over time. Term life insurance, on the other hand, is temporary and has no cash value component, so there is nothing to borrow against.

With permanent life insurance, part of your premium payments goes into a separate account that builds up cash value. When there is enough cash value, you can borrow against it. The cash value is used as collateral for the loan, and the insurance company lends you the money. The loan is then repaid with interest, usually at a lower rate than a bank loan or credit card.

Borrowing against your permanent life insurance policy has several advantages:

• No credit check or approval process: There is no long application process, and you don't need to provide a reason for the loan.
• Fast access to cash: You can get the money within a few days.
• Flexible repayment: There is no set repayment schedule, and you can pay it back over several years if needed.
• No impact on credit score: Policy loans are not reported to credit agencies, so they won't affect your credit score.
• No risk to assets: If you don't repay the loan, the worst that happens is a reduced death benefit.

However, there are also some serious disadvantages to consider:

• Interest accumulation: Interest accumulates over time, and if left unchecked, it could drain your policy's cash value.
• Reduced cash value growth: Borrowing against your policy may slow down how quickly your cash value grows.
• Shrinking death benefit: If the loan isn't repaid, it will reduce the death benefit.
• Risk of policy lapse: If the loan amount plus interest exceeds the policy's cash value, your policy could lapse, leaving you without coverage and potentially facing tax penalties.
• Possible tax consequences: If your policy lapses before the loan is fully repaid, you may owe income tax on the money you borrowed.

Before taking out a loan against your permanent life insurance policy, it's important to consider the potential risks and disadvantages. Discipline with making regular payments and keeping up with premiums is essential. It's also crucial to understand the terms of your policy and the potential tax implications.

In conclusion, borrowing from permanent life insurance can be a convenient way to access cash, but it's important to understand the risks and potential drawbacks before making a decision.

Pros and cons of borrowing from life insurance

Borrowing from your life insurance policy can be a quick and easy way to get cash. However, it is not without its risks. Here are some 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 rates: Policy loans have lower interest rates compared to traditional personal loans or credit cards, typically ranging from 5% to 8%.
• Flexible repayment: There is no set repayment timeline, so you can make payments as it suits your budget.
• Cash value continues to grow: The funds borrowed remain in your policy, gaining interest, and you can continue to build the cash value of your policy.

Cons

• Minimum cash value required: You need to have built up sufficient cash value in your policy before you can borrow against it. This can take several years, depending on the type of policy.
• Borrowing amount limited: You can typically borrow up to 90% of the cash value of your policy. If you need to borrow more, you may need to explore other financing options.
• Reduced death benefit: If you do not repay the loan before your death, the outstanding balance will be deducted from the death benefit paid to your beneficiaries.
• Risk of lapse: Interest continues to accrue on the loan, and if it exceeds the policy's cash value, the policy could lapse. This could result in tax implications and a loss of coverage.

Interest rates and tax implications

Borrowing from a life insurance policy can be a quick and convenient way to access cash. However, it's important to understand the interest rates and tax implications before making a decision. Here are some key points to consider:

Interest Rates

Life insurance policy loans typically offer lower interest rates compared to traditional personal loans or credit cards. The interest rate charged by the insurance company is often referred to as a "spread". This spread can vary, ranging from as low as 0.25% to around 2%. It's important to choose a policy with a low loan spread to minimize the cost of borrowing.

Tax Implications

The tax implications of borrowing from a life insurance policy can be complex and depend on several factors. Here are some key considerations:

• Generally, the loan amount itself is not considered taxable income as long as it doesn't exceed the sum of the insurance premiums you've paid.
• If you repay the loan in full before your death, there are usually no tax consequences, and the full death benefit will be paid to your beneficiaries.
• However, if you don't repay the loan before your death, the outstanding loan amount, including any accrued interest, may be deducted from the death benefit paid to your beneficiaries.
• If your policy lapses or you surrender it before fully repaying the loan, you may owe income taxes on any investment gains or interest earned on the cash value of the policy. This is calculated by subtracting the net premium cost (total premiums paid minus distributions received) from the cash value of the policy.
• It's important to note that the specific tax consequences can vary depending on your location and individual circumstances. Consult a tax advisor or financial professional for personalized advice.

Impact on death benefits

Borrowing from your life insurance policy can have a significant impact on death benefits. If you don't pay back the loan before you pass away, the loan balance will be deducted from the death benefit, meaning your beneficiaries will receive less money. This reduction in the death benefit is done on a dollar-for-dollar basis.

The impact on death benefits can be mitigated if you pay off the loan before you pass away. In this case, there will be no deduction from the death benefit. However, if you pass away before fully repaying the loan, not only will your beneficiaries receive a reduced benefit, but they will also have to pay any remaining interest you owe.

It's important to note that the interest on the loan balance can accumulate over time, especially if you're not making regular payments. This can cause the loan amount to exceed the policy's cash value, which may result in the policy lapsing. In such cases, you may also owe taxes on the borrowed amount. Therefore, it's crucial to keep an eye on the loan balance and ensure it doesn't exceed the policy's cash value.

While borrowing against your life insurance policy can provide financial flexibility, it's essential to consider the potential impact on death benefits and ensure that you have a solid repayment plan in place.

Repayment options

There is no formal repayment schedule for life insurance loans, and policy owners are not required to repay the loan. However, if you don't pay it back, the outstanding amount will be deducted from the death benefit and your beneficiaries will receive less money. It is in your best interest to pay back a life insurance loan as soon as possible. The longer the loan is left unpaid, the more interest you will end up owing.

Policy loans can be repaid in one of three ways:

• Ideally, you would repay your loan with cash payments to the life insurance company. This increases both the policy account value and the death benefit by the amount of the repayment on a dollar-for-dollar basis.
• If the costs being charged in a policy can be reduced, and the cash value is then more than enough to cover reduced costs, a policy loan can be repaid with "excess" cash value. However, if the loan repayment amount is greater than the amount of the policy cost/tax basis, then repaying this way can trigger a taxable event.
• If your policy loan balance is still outstanding when you die, the loan balance will be deducted from the death benefit. This is the most tax-efficient means of repayment, as death benefits are received tax-free.

Frequently asked questions