There are a few details to be aware of before borrowing from your life insurance policy, even though it can be a quick and simple way to have cash on hand when you need it.
Most importantly, only whole life insurance or universal life insurance policies, both of which are permanent life insurance policies, may be used as collateral for a loan.
There is no cash value in term life insurance, which many people find to be a more affordable and practical option. It is only intended to last for a short time, typically between one and thirty years.
A term life insurance policy, though, can occasionally be changed into a permanent one with a cash value component.
Life Insurance Overview
Many consumers find permanent life insurance to be an appealing option. It not only offers everlasting protection, but it also accrues cash value that you can draw upon in the future. Additionally, you are able to borrow money against your life insurance policy.
As an emergency fund you hope you’ll never need to use, a life insurance loan can help you get cash when you need it. Although it’s frequently simpler and less expensive than a conventional bank loan, borrowing from your life insurance policy carries some risk.
You can decide if a life insurance loan is the best option for you by being aware of your options as well as the advantages and disadvantages of such a loan.
Policies You Can Borrow From
Although more expensive than term insurance, whole-life and universal life policies have no set expiration date.
The policy is in effect for the insured person’s entire lifetime if sufficient premiums are paid. Despite the fact that the monthly premiums are higher than the term, the policy’s cash value account grows as a result of contributions that go above the cost of insurance.
The cash value serves as a buffer against the escalating insurance costs as you get older. This keeps premiums stable throughout your life and prevents them from rising to unaffordable levels in your later years.
The face value, the death benefit (which is frequently the same as the face value), and the cash value are the three key values of permanent life insurance.
The death benefit is not increased by the cash value, as is a common misconception. It only applies to certain kinds of permanent insurance; for the majority of policies, it has no impact on the death benefit.
Depending on the type of policy, the rate at which cash value grows varies.
For instance, in a regular universal life policy, it increases in accordance with the current interest rates, whereas in a variable universal life policy, the owner invests the cash value in the stock market (and it increases in line with that).
Usually, it takes at least a few years for the cash value to increase to a point where borrowing is feasible.
How a Life Insurance Loan Works
Since you are essentially borrowing from yourself, policy loans are different from bank loans and credit cards in that they don’t affect your credit and don’t require an approval process or a credit check.
No justification is necessary when borrowing from your policy, so it can be used for anything from bills to vacation costs to a dire financial situation.
As long as the policy is in force (and provided it is not a modified endowment contract), the loan is not taxed because the IRS does not recognize it as income.
Although the interest rates on policy loans are typically much lower than those on bank loans or credit cards, it is still expected that they will be repaid with interest, and there is no requirement for a monthly payment.
Your available cash value and death benefit are decreased by a policy loan. Your beneficiaries will receive less money if you pass away with a life insurance loan that you still owe money on.
Pros and Cons of Borrowing from Your Insurance Policy
You can access money with the help of life insurance loans, which is a desirable alternative to applying for a conventional loan. But using your life insurance to borrow money has both benefits and drawbacks.
Let’s say you have a universal life insurance policy with a $50,000 cash value.
Since there are few requirements, no credit checks, and low-interest rates, borrowing against your life insurance policy may seem like a smart idea when you need money to pay for some unforeseen home repair costs.
You are permitted to borrow up to 90% of your cash value from your insurance company. In this case, it means that a $45,000 life insurance loan is available.
Life insurance loans don’t have a set repayment schedule like other loans do. As a result, you can pay it back when it’s convenient for you, though delaying repayment for an extended period of time can have negative consequences.
Despite being frequently more affordable than personal loans, life insurance loans do have interest charges. Your policy might also expire if the interest builds up more quickly than you can pay off the loan.
You might not only lose your insurance as a result of this but there might also be financial repercussions.
Even if your policy is still in effect, if you die before repaying the loan, your family might have less money available to them.
Your death benefit will be reduced by the amount you owe, giving your beneficiaries a lower payout.
How to Borrow Money from Your Life Insurance
It’s not too difficult to borrow money from your life insurance policy. Most of the time, you can ask for a loan by calling your insurance provider. In other situations, you might be able to finish everything online.
According to John Graves, founder and managing partner of G&H Financial Group, “There are no lending requirements and no restrictions on the use of funds.”
A life insurance policy will frequently come with lower interest rates than a bank loan would.
The money is also more easily accessible if you have a spotty credit history because loan eligibility is based on your life insurance cash value rather than your creditworthiness.
When you take out a loan against your policy, you can usually pay yourself interest, but your insurer might impose a spread as a fee.
Your insurer will determine how much you’ll have to pay to borrow money. Though a spread can be as low as 0%, the typical range is 0.25% to 2%.
You can typically extend repayment on a life insurance loan for as long as you’d like, but that doesn’t mean you should.
The best course of action is to make consistent cash payments up until the loan balance, plus interest has been fully repaid. Your death benefit will be used to pay off the loan balance if you default on it before passing away.
Paying Back the Loan
Even with low-interest rates and a flexible repayment plan, you should still make on-time loan payments in addition to your regular premium payments.
If left unpaid, interest is added to the balance and builds up, putting your loan at risk of surpassing the cash value of the policy and leading to the lapse of your policy. You’ll probably have to pay taxes on the amount you borrowed if that occurs.
Insurance companies typically offer numerous chances to keep the loan current and stop it from lapsing.
If the loan is not repaid before the insured person passes away, the loan balance plus any interest due is deducted from the death benefit distribution that is intended for the beneficiaries.
For use while the insured is still alive, you can borrow money from life insurance that has a cash account. But here are three dangers to watch out for:
- You lessen the death benefit: You lessen the death benefit by withdrawing funds from the life insurance policy while you are still alive.
- You alter the warranty: Guarantees for permanent insurance are founded on specific presumptions. The most important of these is that you will consistently pay your premiums and build up a certain amount of cash. If you withdraw cash, you run the risk of not having enough money to cover the guarantee.
- You ultimately pay more money: Even when you withdraw cash, some permanent policies will guarantee the guarantee, but at a price that may require you to pay a higher premium to make up the difference.
- When you need money, borrowing from your life insurance policy can be a simple way to get it.
- Only whole life or universal life insurance policies are eligible for borrowing.
- If policy loans are not repaid, the death benefit is reduced.
- The loan balance accrues interest, which, if unpaid, can result in a policy lapse, according to life insurance companies.
- Cash value can only be accrued by permanent life insurance. Term insurance doesn’t.
The Bottom Line
In addition to its death benefit, permanent life insurance with a cash value accumulation may offer specific living advantages. Among them are the options for cash value withdrawals and borrowing against the policy’s cash value.
When you take out a loan against your insurance policy, your insurer lends you the cash and uses it as security; you don’t actually take any money out of the policy itself.
As a result, the policy’s cash value can keep growing. However, it’s crucial to confirm with your insurance provider how interest and any dividends will be calculated and paid when you have an open loan.
Although they can be useful financial instruments, policy loans can also lead to financial instability. Your policy might lapse if you don’t pay interest, and the full amount of the loan might become taxable.
Furthermore, your beneficiaries may suffer a great deal if you die because the death benefit will be reduced by the loan balance and any accrued interest.
Before taking out a loan against a life insurance policy, be sure to carefully weigh the advantages and disadvantages of such a move in the context of your particular circumstance.
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