Permanent life insurance policies with sufficient cash value normally allow for policy owners to pull money from their policy in the form of a loan. Loans from life insurance policies can have distinct tax advantages, and they do not permanently reduce the death benefit paid to beneficiaries. Here we discuss the benefits and drawbacks of taking loans from your life policy.
What Is a Life Insurance Loan?
A life insurance loan is when a policy owner takes money out of their policy from the available cash value. The money is not taken out in a surrender, so it does not permanently reduce the death benefit of the policy. It must, however, be paid back or the death benefit is reduced by the amount of the outstanding loan when a claim is filed. While the loan is outstanding, it does accrue interest which adds to the balance of the loan. If the loan plus the interest accrued becomes too large, it may cause the policy to be surrendered, so it is important to understand and manage your balance.
Types Of Life Insurance That Allow Loans
Any life insurance policy that has a cash value will allow a loan to be taken against that value under normal circumstances (assuming sufficient cash value exists to meet minimum loan requirements). This means that whole life, universal life, and variable universal life insurance contracts all allow loans to be taken out. In other words, any permanent life insurance policy.
The type of life insurance that does not allow a loan to be taken out is term life insurance. Term life insurance has no cash value, and therefore it is impossible to loan against this product type. Term insurance does not build cash value because it is not a permanent form of life insurance, and it would be unnecessary to have an accruing value as this would add unnecessary additions to premium payments.
How Much Money Can be Loaned from A Policy?
Life insurance companies allow a certain percentage of the current cash value of a policy to be loaned out. Usually, this is 90% of the cash value, but your contract will spell out the specifics. Because the amount of money you can take out is dependent on the current cash value, and not the death benefit, you will see the loan-able amount grow as the policy ages and cash value grows. In the first few years, very little money will most likely be available. After some time, the cash balance will become more substantial and there will be a lot more money available to take out in the form of a loan. You can never take more than the current cash value, or the life insurance company would force you to surrender the policy.
How to Request a Loan
A loan is typically fairly simple to request. A call to your insurance companies’ customer service line, or to your agent will allow you to request the loan. You do not usually need to fill out any paperwork, but you may need to sign a form if your company requires it. Before you request a loan, verify the amount of available cash value and the total balance available for the loan. Make sure you understand the interest rate as well because it will not be an insignificant percentage. The loan will be paid either directly into your bank account, or a check will be sent by mail. You may be able to request expedited shipping if necessary.
Only an owner can request a loan. If the insured person and the owner are different people, the insured person does not have any rights to the cash in the policy and they can not borrow against the cash or the surrender value of the policy.
What Can you Use the Loan For?
A nice feature of life insurance loans is that they can be used for anything. Common uses can be:
- Paying a higher interest credit card with a lower interest loan.
- Paying off a car.
- A down payment on a house.
- A vacation.
- Starting a business
- Catching up on bills.
- A college education.
The possibilities are endless. It is your money to do with as you wish.
Advantages Of Loans
- The biggest benefit a loan provides is the ability to access value from your policy during a time of need. As discussed, the loan can be used for anything.
- A loan does not permanently reduce the death benefit of a policy. If a loan exists at the time of a death claim, the amount of the loan is deducted from the death benefit payout. A withdrawal from a life insurance policy may permanently reduce the face amount of the contract.
- A loan is not taxable. There is one case where it may be, if the policy is a modified endowment contract (MEC). If you took more money out of the policy than you paid into the policy in premiums, and you then surrender the policy, you will be taxed on any gains taken out. But you will not be taxed if the money remains out in the form of a loan and the policy stays intact.
- The value of the loan may earn interest in a collateral loan account within the policy, and this reduces the effective interest rate on the loan.
- Loans from life insurance policies have flexible repayment options. See below for more information about this.
- Loans are not subject to surrender charges like withdrawals might be. Some policies have surrender charges for a certain amount of time, detailed in a surrender schedule.
Disadvantages Of Loans
- Loans are charged interest, which go straight in the insurance company’s pocket. They may also reduce dividend payments in a whole life policy or reduce the potential for higher market returns in a variable policy. A loan will cost a policy owner money from their policy value in almost all cases.
- If a loan gets too large, the rate of interest accruing plus the premium payments due may become too large for a policy owner to keep up with. This can cause a policy to lapse and the insured person to lose valuable coverage. This can be avoided with partial repayments or by maintaining sufficient cash value to prevent a lapse.
- Loans reduce the death benefit by the amount of the outstanding loan at the time of death, which can prevent your beneficiaries from getting the financial protection that they need.
Repaying A Life Insurance Loan
Life insurance loans can be paid off whenever the owner wants. There is no set repayment schedule, but insurance companies may send a bill for the interest accrued, or they may allow you to set up a repayment schedule if you desire one. An owner can send payment once a year, once a month, or more often if they desire. The loan can also stay outstanding and never paid off if the owner does not wish to pay the money back.
A loan will not default unless there is no additional cash value in a life insurance policy to add to the loan. An unpaid loan will grow by the amount of interest accrued. You may be able to use dividend payments to repay outstanding loans on the policy, so you may never actually need to come out of pocket.