Need money fast? Your life insurance policy may be an easy source of borrowed cash — but it’s not the right strategy for everyone. To decide if a life insurance loan is right for you, first take a few minutes to learn how these loans work, what they cost, and the potential pitfalls. This small effort now could spare you from unpleasant surprises later.
Read on for a walk-through of the mechanics of borrowing from life insurance, including the terms, tax consequences, borrowing limits, and the pros and cons. With that base of knowledge, you’ll be ready to decide if a life insurance loan is right for you.
What is a life insurance loan?
A life insurance loan is a debt that uses your policy’s cash value as collateral. If you have enough cash value in your life insurance to cover the debt, this type of loan could be an easy, flexible, and fast way to raise cash.
Low interest, no repayment
You’ll find the terms on life insurance loans to be competitive. The interest rate will be much lower than what you’d see with credit card debt or an unsecured personal loan. Even better, repayment is optional. As strange as that sounds, it benefits your insurer to be flexible on repayment. Here’s why. When you take a loan on your life insurance, the insurer immediately reduces your death benefit by the loan amount. If you don’t pay the interest, the insurer periodically adds the accrued charges to the loan balance. That raises your balance over time and lowers your available death benefit.
If you decide to surrender your policy, the insurer deducts your outstanding debt, including interest, from your surrender value. And if your cash value declines so that it’s worth less than your loan balance, your insurer can lapse the policy for being underfunded. The takeaway is that it’s unlikely your insurer will lose money on the loan.
Since the risk is low for the insurer, that creates a flexible borrowing situation for you. But it’s your responsibility to keep making those premium payments so your policy doesn’t lapse. You also must pay attention to the accrued interest and how it affects your death benefit over time.
Cash value growth
Another consideration is how the loan will affect the growth of your cash value going forward. It’s likely your cash value growth will slow, but by how much depends on your policy type. Here are two examples:
- A variable universal life policy invests cash value amounts in investment accounts, like mutual funds. The funds you borrow will normally be deducted from your investment accounts while the loan is outstanding. But, your policy may allow you to earn a lower fixed rate on the cash which offsets your interest charges. If you’re charged 4% interest on the loan, for example, you might earn 3% on the cash value you borrowed against. That brings your net charges to 1%.
- When you borrow against a whole life insurance policy, your cash value does continue earning dividends. The dividends might be enough to pay the interest on your loan, but that would divert them from being reinvested into your cash value.
Tax consequences of a life insurance loan
A life insurance loan is not taxable unless the loan amount is greater than what you’ve paid in premiums. However — and this is important — the loan will become taxable if you surrender or lapse your coverage. Basically, if your policy is cancelled for any reason, the IRS treats your loan and the outstanding interest as ordinary, taxable income.
Repaying a cash value loan
You can address most of the negatives of life insurance loans by repaying the debt. If you pay the money back, your death benefit and cash value are restored. You also sidestep the potential for tax consequences.
To repay the loan, you’ll have to ask your insurer for the repayment address and then set up automatic payments from your checking account. While the insurer should send you loan statements periodically, don’t expect to receive bills with payment stubs.
How to borrow against life insurance
Borrowing against your life insurance is easy. Typically, you just call your insurer and ask for a loan. There will be no application or credit check. Again, because the insurer has the policy’s cash value as collateral, the process can be informal. You might need to confirm on a recorded call that you are requesting the loan, but it won’t be more complicated than that.
The insurer will pop a check in the mail and you should have the funds within a few days.
What types of life insurance can I borrow from?
You can normally borrow from any life insurance policy that has cash value, including whole life insurance, universal life insurance, and variable life insurance.
How much can I borrow from my life insurance policy?
Your cash value balance sets the upper limit on your borrowing capacity. Most insurers will cap policy loans at 90% of your cash value.
Should I take a loan against my life insurance policy?
Only you can decide if a life insurance loan is the right solution. Consider your goals for your life insurance, now and in the future, as you review the pros and cons below.
- Life insurance loans are quick. You should have the funds within a week.
- Life insurance loans don’t require credit checks. Your insurer won’t care — or charge you a higher interest rate — if your credit score dropped last week. The loan also won’t show up on your credit report.
- Life insurance loans don’t have to be repaid. The flexibility of a life insurance loan is an advantage if two factors are true. One, you must intend to keep paying your life insurance premiums indefinitely. And two, your relatives won’t need your full death benefit.
- Your loan will be taxable if your coverage ends. Once you accept the loan, you are committed to paying your policy premiums. Otherwise, your low-cost loan will get substantially more expensive when the IRS gets involved.
- The loan balance reduces your death benefit. You might think through how your beneficiary will be affected by the lower death benefit. This factor becomes irrelevant, though, if you pay off the loan while you are living.
- Life insurance loans don’t have to be repaid. The lack of repayment requirements is a disadvantage in two scenarios. One, you can’t afford your premium payments. And two, your relatives need your full death benefit.
Alternatives to borrowing against life insurance
Life insurance loans are quick and easy, but they do lock you into those premium payments indefinitely. That could be a dealbreaker if you expect your current cash flow crunch to be ongoing. Fortunately, there are two alternative strategies for raising cash from your life insurance. You can either sell your insurance in a life settlement or surrender it back to the insurer. Both would eliminate your future premium payments entirely.
1. Life settlement
In a life settlement, you sell your life insurance to a third-party investor for cash. The transaction takes a few months to complete, but you will net far more cash than what’s available to you via a policy loan. Sales prices can range from 20% to 60% of the policy’s death benefit.
Once the transaction closes, the new policy owner will control the death benefit and the cash value. That owner will also pay the policy premiums going forward.
You may be eligible for a life settlement if you are at least 65 years old and your policy value is $50,000 or more. If you’re considering this route, reach out to Harbor Life Settlements for a free policy review and estimate.
2. Policy surrender
You could also surrender your policy back to the insurer. This would cancel your coverage and death benefit immediately. As part of that cancellation, the insurer would close out your cash value account and send you a check for the balance, less any surrender fees.
Surrendering your policy makes the most sense when you’re too young for a life settlement and you can’t afford to keep the policy in force. This is because a life settlement can generate two to four times more cash than a surrender. That difference can add up to tens of thousands of dollars. If you aren’t quite 65, the potential for a larger life settlement payout may convince you to keep your life insurance for a few years until you can sell it.
To learn more about life settlements and to find out what your policy might be worth, contact Harbor Life Settlements today. Our team is happy to review your coverage, answer your questions, and help you identify how to generate maximum cash from your life insurance policy.