Borrowing From Life Insurance: What You Can And Can't Do

Life insurance is often thought of as a safety net for loved ones after you're gone, but did you know that certain types of life insurance can provide financial benefits while you're still alive? Borrowing against your life insurance policy allows you to access funds when you need them, using the cash value that builds up over time. This option is typically only available with permanent life insurance policies, such as whole or universal life insurance, which accumulate cash value. Term life insurance policies are cheaper but don't have a cash value component, so you can't borrow against them.

Whole life insurance

The cash value of a whole life insurance policy grows over time at an interest rate set by the policy's terms. This interest rate 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. It usually takes a few years for the cash value to build up to a level where it can be borrowed against.

Borrowing against a whole life insurance policy can be a quick and easy way to access cash. There are no loan requirements or qualifications other than the cash value amount available, and the funds can be used for any purpose. The interest rates on these loans are relatively low, typically ranging from 5% to 8%. Additionally, there is no set repayment schedule, and the cash value continues to grow while the loan is outstanding.

However, there are some risks associated with borrowing against a whole life insurance policy. If the loan is not repaid before the insured person's death, the loan amount and any interest owed will be deducted from the death benefit, reducing the amount paid out to beneficiaries. Additionally, if the loan amount exceeds the policy's cash value, the policy could lapse, and the insured person may owe taxes on the amount borrowed.

Universal life insurance

The cash value of a universal life insurance policy will either earn interest based on current market rates or be invested by the owner in the stock market. This cash value can be borrowed against, with the cash value serving as collateral for the loan. The loan is not recognised as income by the IRS and is therefore tax-free as long as the policy stays active. There is also no impact on the policyholder's credit score.

However, it is important to note that borrowing against a universal life insurance policy is not without risk. If the loan is not repaid before the death of the insured, the loan amount plus any interest owed will be deducted from the death benefit paid to beneficiaries. Additionally, if the loan amount exceeds the policy's cash value, the policy could lapse, resulting in the loss of coverage and a potential tax bill.

Before taking out a loan against a universal life insurance policy, it is important to carefully consider the potential risks and consult with a financial advisor or estate planning attorney to understand the tax implications and potential impacts on beneficiaries.

Variable universal life insurance

Variable universal life (VUL) insurance is a type of permanent life insurance policy that allows for the cash component to be invested to produce greater returns. VUL insurance policies are built like traditional universal life insurance policies but let you invest the cash value in the market via subaccounts.

The return on the cash component is not guaranteed year after year. You can even lose money. If your cash value balance is too low, you may need to pay higher premiums to keep your VUL active.

VUL is similar to variable life insurance, but unlike variable life, it allows you to change your premium payment amount. While VUL insurance offers increased flexibility and growth potential over other life insurance options, you should carefully assess the risks before purchasing it.

Here's how VUL insurance works:

• You must pay enough each year to cover the ongoing insurance costs of your policy. The insurer will deduct this amount from your premiums.
• The remainder of your premiums will go toward your policy's cash value.
• You pick how to invest your cash value from a variety of subaccounts. Your interest and future growth depend on the investment performance.
• If your investments do well, your cash value will grow more quickly.
• The growth of the VUL insurance policy's cash value is tax-deferred.
• Policyholders may access their cash value by taking a withdrawal or borrowing funds.
• If your investments do poorly, your cash value will not grow as quickly. It is possible to lose money with a VUL.
• If you face significant losses, you may need to make larger premium payments to cover the cost of your life insurance and rebuild your cash value. Otherwise, your policy would lapse, and you would lose insurance protection.

Permanent life insurance

The process of taking out a loan against a permanent life insurance policy is straightforward. The policyowner fills out a form from the insurer, and the money is deposited into their account, usually within a few days. There are no loan requirements or qualifications other than the available cash value amount, and the funds can be used for any purpose. The interest rates on these loans are typically lower than those of personal loans or credit cards, ranging from 0% to 2% or 5% to 8%, depending on the insurance company and the policy.

It is important to carefully consider the pros and cons of borrowing against a permanent life insurance policy before taking out a loan. While it can provide quick access to cash with flexible repayment terms and no credit check, failing to repay the loan can reduce the death benefit and potentially cause the policy to lapse. Additionally, if the policy lapses during the repayment period, the policyowner may owe income tax on the amount borrowed.

Cash value life insurance

The cash value of a life insurance policy is like a savings account, where a portion of the premiums paid goes into accumulating this value. This value grows over time, earning interest at either a fixed or variable rate, depending on the type of permanent policy. Whole life insurance, for example, guarantees a fixed rate of return, while variable universal life insurance invests the cash value in the stock market, offering the potential for higher returns but also carrying greater risk.

One of the main advantages of cash value life insurance is the flexibility it offers. Policyholders can borrow against the cash value, providing a quick and easy way to access cash. There are typically no loan requirements or qualifications other than having sufficient cash value built up, and the funds can be used for any purpose. The interest rates on these loans are also relatively low compared to other types of loans.

However, there are some potential drawbacks to consider. If the policyholder fails to repay the loan and interest, the policy could lapse, resulting in a loss of coverage and a potential tax bill. Additionally, any outstanding loan balance and interest will be deducted from the death benefit paid to beneficiaries. It's important to carefully manage the cash value and monitor the loan size to avoid these risks.

Overall, cash value life insurance can be a valuable option for those seeking lifelong coverage and the ability to access funds during their lifetime. It offers flexibility and financial security but requires careful management to avoid potential pitfalls.

Frequently asked questions