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Life insurance is an important tool that helps you protect your loved ones from financial hardship if you die.
There are also benefits to life insurance beyond the death benefit. If you have a policy with a cash value element, you can borrow money from your life insurance. Cash value life insurance can be one of the most convenient and inexpensive financing options available. But there are also pitfalls to avoid if you go this route.
What types of life insurance policies can you borrow from?
Most permanent life insurance policies offer the ability to borrow money against the cash value.
Permanent life insurance policies increase cash value as you pay the premiums. The cash value portion of the policy earns interest or is linked to an investment account or index, allowing you to grow the money over time.
Term life insurance, by comparison, is not life insurance you can borrow from. Term life insurance is a relatively inexpensive insurance option designed to protect people during the years when they need it most, such as the working years until their mortgage is paid off. These policies have no cash value.
How does a life insurance policy loan work?
According to Barry Flagg, founder of Veralytic, an independent life insurance analysis company, policy loans come in the form of direct loans or indirect automatic premium loans.
With a direct loan, you are essentially borrowing money from yourself, with the cash value of the policy serving as collateral. For this reason, you don’t have to pay tax on the money you withdraw. The insurance company will also charge interest (called spread).
Flagg explains that you basically pay yourself interest, minus a spread charged by the insurance company. Usually this can be as low as 0.25% (even 0% in some cases) or as high as 2%.
“Choosing a policy with a low lending spread can make a big difference,” says Flagg. “Policy loans reduce both the policy account value and the death benefit by the amount of the loan anyway on a dollar-for-dollar basis.”
If you repay the policy loan before your death, there is no deduction from the death benefit.
Automatic premium loans
An Automatic Premium Loan (APL) allows the insurer to use your cash value to pay your life insurance premiums, if you don’t.
“While insurers typically send notice of such automatic premium loans, consumers often don’t understand the implications,” Flagg says. “So this type of policy loan can accumulate unintentionally for years.”
Flagg says interest is also added to the balance, often at unfavorable rates. So when policyholders are unaware of these implications, APLs can become quite large, eroding cash value and leading to policy lapse.
How does a life insurance loan affect your policy?
Before taking out a policy loan, contact your insurance company to find out how the loan will affect the components of your policy. You can do this by requesting a police force illustrationwhich shows how the performance of the policy will be affected if you borrow the money, repay the loan, or maintain the loan.
The current illustration should also indicate whether the interest is paid out of pocket or borrowed. The insurance company will charge interest in advance (in advance for the whole year) or in arrears (at the end of the insurance year).
How much money can you borrow on a life insurance policy?
Loans are available on life insurance policies when there is sufficient cash value. The amount you can borrow is represented as a percentage of the cash value. Every life insurance company has rules about how much policyholders can borrow, but Flagg says it’s usually around 90% to 95%.
Using these percentages, if your policy cash value is $50,000, you may be able to borrow $45,000 to $47,500.
How to repay a life insurance loan?
Unlike most types of loans, life insurance policy loans do not have a specific repayment period. You can take as long as you want.
However, there may be negative consequences if you hold the funds indefinitely because interest accrues. Therefore, if you are borrowing against your policy, it is advisable to repay the loan in a timely manner.
Policy loans can be repaid in three ways.
Ideally, you would repay your loan by paying money to the life insurance company. “Reimbursing cash increases both the account value of the policy and the death benefit of the reimbursement amount, dollar for dollar,” says Flagg.
Flagg says that if the costs charged in a policy can be reduced and the cash value is then more than enough to cover the reduced costs, a policy loan can be repaid with “excess” cash value. He cautions, however, that if the loan repayment amount is greater than the policy cost/tax base amount, repayment in this way may 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. Your beneficiaries will receive a reduced benefit. Even so, Flagg says that because death benefits are received tax-free, repaying policy loans this way is the most tax-efficient way of repayment (compared to repaying with money that has already been taxed or a withdrawal of excess cash value that may be taxed). ).
What happens if you can’t repay a life insurance loan?
If you do not repay your policy loan or make interest payments, interest will accrue and be added to the balance. If this goes on long enough, the amount borrowed could exceed the cash value of the policy, causing the policy to lapse.
“Then the entire amount of the loan becomes taxable as notional income,” says Flagg, which he explains is taxable income with no actual cash income to pay the tax. The loan balance is also taxed at ordinary income rates instead of more favorable capital gains tax rates.
If you die before repaying the balance of the loan, the insurance company will deduct it from your death benefit. So your beneficiaries will receive less and essentially repay the loan on your behalf.
Advantages and disadvantages of borrowing money from life insurance
Before borrowing money from your life insurance policy, consider these pros and cons.
- No credit check required: Since you are borrowing your own money, no formal credit check is required to qualify for a policy loan.
- Low interest rate: Policy loans are a low interest financing option. Interest rates vary between approximately 5% and 8%, depending on whether they are fixed or variable.
- Pay back whenever you want: There is no formal repayment schedule, so you can make payments toward the balance based on your budget and cash flow.
- Cash value continues to grow: The cash value of your policy simply acts as collateral, so the funds continue to sit in your policy and earn interest.
- Minimum Cash Value Required: You must have sufficient cash value before you can take out a loan. So if your policy is relatively new, it may take years to build up a decent cash value.
- Limited borrowing amount: You can only borrow up to a certain percentage of your cash value. So if you need to borrow more, you may need to explore other (potentially more expensive) financing options.
- Reduced death benefit: If you do not repay your loan before your death, it will be deducted from your beneficiary’s death benefit.
- Lapse risk: Even if you don’t have to repay your loan on a set schedule, interest will continue to accrue and the insurer will still charge for policy-related expenses. If your loan balance exceeds the cash value of the policy, the policy may lapse. That would mean you would have to make an infusion of bounty money to keep it going.
Alternatives to borrowing money from a life insurance policy
When done correctly, a life insurance policy loan can be a convenient, low-interest way to borrow money. However, if you want to avoid the risks associated with borrowing your life insurance, consider these other ways to leverage cash value.
Cash Value Withdrawal
Instead of borrowing money from your life insurance, you can simply withdraw money from it. As long as you only withdraw the amount you’ve paid in premiums so far, you won’t have to pay tax on the funds. The downside is that a withdrawal will generally reduce your death benefit.
If you no longer need life insurance, one option is to redeem your life insurance policy for money. This can be a good option if you no longer have dependent children or if you have a lot of debt and need cash for your retirement. Remember that some policies have surrender charges, which reduce the amount you receive.
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