Life insurance plans are frequently viewed as financial safety nets for beneficiaries in the case of a policyholder’s death. However, many policyholders may be unaware that they can use their life insurance policy to meet financial demands during their lifetime. One such option is to borrow against the cash value of a life insurance policy.
This can be a significant resource in times of need, providing liquidity without requiring the surrender of the policy or triggering taxable events. In this article, we’ll look at the process of borrowing from life insurance, including the benefits, considerations, and potential dangers.
How Insurance Loans Policy Work
Borrowing from a life insurance policy operates differently from traditional loans. With policy loans, individuals essentially borrow from themselves, leveraging the cash value accumulated within their policy.
Unlike bank loans or credit cards, policy loans do not necessitate credit checks or approval processes, offering a streamlined borrowing experience.
The borrowed funds can be utilized for various purposes, from covering bills to addressing financial emergencies, without the need for explanations.
Moreover, policy loans are not recognized as income by the IRS, preserving their tax-free status as long as the policy remains active.
Implications and Consequences
It is important to recognize that policy loans are not without consequences. Here are some of the implications associated with borrowing from life insurance:
Reduced Death Benefit
Borrowing against the cash value of a whole life or universal life insurance policy diminishes the death benefit if the loan is not repaid. This can have significant implications for beneficiaries and their financial security.
Risk of Policy Lapse
Failing to repay the loan and accrued interest can jeopardize the policy’s sustainability, potentially leading to a lapse in coverage. This could leave the policyholder and their beneficiaries unprotected.
Limited to Permanent Life Insurance
Policy loans are only available for permanent life insurance policies, as they accumulate cash value over time. Term life insurance policies do not offer this borrowing option.
Types of Life Insurance Policies
The two types of life insurance are:
Term Life Insurance
Term life insurance provides coverage for a specific period, typically ranging from one to 30 years. Unlike permanent life insurance, term policies do not accumulate cash value.
However, in some cases, term life insurance can be converted to a permanent policy, unlocking the potential for cash value accumulation.
Permanent Life Insurance
Unlike term life insurance, which provides coverage for a specific period, permanent life insurance policies endure throughout the policyholder’s lifetime.
Whole life insurance and universal life insurance are two common types of permanent life insurance that offer the opportunity to accumulate cash value over time.
Whole Life Insurance
This type of policy guarantees a death benefit and accumulates cash value at a predetermined rate. It provides lifelong coverage with fixed premiums and guaranteed cash value growth.
Universal Life Insurance
Universal life insurance offers more flexibility than whole life insurance, allowing policyholders to adjust their premiums and death benefits over time. It also accumulates cash value, which can fluctuate based on the policy’s performance.
How to Borrow from Life Insurance
Below are the processes you need to follow to borrow from life insurance
Assess Policy Terms
Before considering borrowing, it’s essential to understand the terms of your whole life or universal life insurance policy. Determine the available cash value that can be borrowed against and review any associated fees, interest rates, and repayment conditions.
Contact your life insurance company to initiate the borrowing process. Complete the loan application, specifying the desired loan amount and providing any required documentation.
Interest and Repayment
Life insurance companies typically charge interest on policy loans, which accrues on the outstanding loan balance. It’s crucial to make timely interest payments to prevent the loan from impacting the policy’s performance.
Failure to repay the loan and interest can diminish the cash value and potentially cause the policy to lapse.
While policy loans offer repayment flexibility, it’s imperative to adhere to a timely repayment schedule. Despite typically lower interest rates and no mandatory monthly payments, neglecting loan repayment could jeopardize the policy’s integrity.
Unpaid loans accumulate interest, increasing the risk of policy lapse and tax liabilities.
Insurance companies typically offer mechanisms to prevent lapses, but borrowers must remain vigilant in managing their loan obligations.
Upon the insured’s death, any outstanding loan amount, along with accrued interest, is deducted from the death benefit, potentially reducing the payout to beneficiaries.
Can I borrow against a term life insurance policy?
No. There is no cash value component in term insurance, so nothing can be borrowed.
You can borrow money from life insurance using a cash account for use while the insured is alive. But here are three possible challenges:
You reduce the death benefit: Taking money out of a life insurance policy while you are alive may lower the survivor payout.
You interfere with the guarantee: Permanent insurance promises are predicated on specific assumptions. The most important of these is that you will make your premium payments on time and accumulate a particular amount of cash.
If you take cash out, you may deplete the funds needed to ensure the guarantee.
You’ll end up spending more money: some permanent policies will even ensure the guarantee when you take cash out, but at a cost that could force you to pay more premium to cover the difference.
Frequently Asked Questions
How Much Can You Borrow Against Your Life Insurance Policy?
Each insurance company’s limits will vary, but in general, you can borrow up to 90% of your life insurance’s cash value.
How soon can you borrow against a life insurance policy?
You can borrow from a life insurance policy once there is enough cash value to cover the loan amount. Depending on how your policy is structured, this may take several years to accumulate.
What Types of Life Insurance Policies Can You Borrow Against?
You can borrow from permanent life insurance policies that accrue cash value. These would normally include whole life and universal life (UL) policies.