While borrowing from your life insurance policy can be a quick and easy way to get cash in hand when you need it, there are a few specifics to know before borrowing. Most importantly, you can only borrow against permanent or whole life insurance. Term life insurance, a cheaper and suitable option for many people, does not have a cash value and expires at the end of the term, generally anywhere from one to 10 years.
A whole life policy is more expensive but has no expiration date. The term lasts the lifetime of the insured. While the monthly premiums may be higher, the money paid in to the policy exceeding what is needed for the death benefit is invested by the life insurance company, creating a cash value after a few years. The whole life policy essentially has two values: the face value, or death benefit, and the cash value that acts as a savings account. Once the money invested increases the amount of the death benefit, the tax-free cash value can then be borrowed against. It is also important to understand that the policy loan is not taken out of your death benefit, but borrowed against it, and the insurance company is using your policy as collateral for the loan.
Unlike a bank loan or credit card, policy loans do not affect your credit and there is no approval process or credit check since you are essentially borrowing from yourself. When borrowing on your policy, no explanation is required about how you plan to use the money, so it can be used for anything from bills to vacation expenses. The loan is also not recognized by the IRS as income, therefore it remains free from tax. However, the policy loan is still expected to be paid back with interest, though the interest rates are typically much lower than on a bank loan or credit card, and there is no mandatory monthly payment.
Even with low interest rates and a flexible payback schedule, it is still important for the loan to be paid back in a timely manner. Unless it is paid out of pocket, interest is added to the balance and accrues whether the bill is being paid monthly or not, putting your loan at risk of exceeding the policy's cash value and causing your policy to lapse. Insurance companies generally give many opportunities to keep the loan current and prevent lapsing. However, in the event of a policy lapse, taxes must be paid on the cash value. If the loan is not paid back before the insured person's death, the loan amount plus any interest owed is subtracted from the amount the beneficiaries are set to receive from the death benefit.
The Advisor Insight
You can borrow money from life insurance that has a cash account for use while the insured is alive. But here are three pitfalls to avoid:
- Don't reduce the death benefit: Taking money out of the life insurance policy while you are alive could reduce the survivor benefit.
- Don't tamper with the guarantee: Permanent insurance guarantees are based on certain assumptions. Chief among these is that you will stick to your premium payments and accumulate cash at a certain level. If you take cash out, you may deplete the amount required to ensure the guarantee.
- Don't end up paying more money: Some permanent policies will even ensure the guarantee when you take out cash, but at a cost which could force you to pay more premium to cover the difference.
The firm of Steven H. Kobrin, LUTCF
Fair Lawn, NJ