More on Life Insurance
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Nine common life insurance myths debunked
You’re only able to take out life insurance loans if you have permanent life insurance, which provides coverage for your entire life and comes with a cash value that accrues interest as long as you’re alive. Term life insurance, which expires after a set period and has no cash value, does not offer a policy loan option.
After the cash value of your permanent policy is high enough — the exact amount varies by insurer — you may be able to take out a loan from your life insurance company. But life insurance loans come with some stipulations that make them more complex than standard bank loans.
A life insurance loan, also called a policy loan, could reduce your policy’s cash value as well as its face value, which means that your beneficiaries could receive a smaller death benefitwhen you die. Additionally, if you don’t pay your loan balance out of pocket, your policy could eventually lapse, and you could even face a large tax burden.
You can take a loan against a permanent life insurance policy, but not a term life policy
A policy loan is useful if you don’t qualify for a bank loan since insurers won’t run your credit before extending a loan
Your policy is your collateral, so if you don’t make loan payments, your coverage can lapse
Most people will avoid complications and save time by buying a term policy and pursuing a loan from a traditional lender
When you take out a life insurance loan, you’re not actually withdrawing from your life insurance. Instead, the insurer extends you the loan, using your cash value as collateral.
"I typically would recommend a client take out a loan against an insurance policy if they are at a point where they no longer need the death benefit to cover the people they initially purchased it for," says Malcolm Ethridge, executive vice president and financial advisor at CIC Wealth. "For instance, a retired couple whose home is paid off and children are financially independent likely does not have a need for a large death benefit once they pass away. The same with a widow or widower."
A policy loan is also worth considering if you don’t want to put up other assets, like a car, as collateral for a loan, or if you wouldn’t qualify for a loan elsewhere.
If you need cash but don’t have good credit, taking out a life insurance loan may be your only option. The life insurance company won’t run a credit check before offering a loan, so you could be approved as long as there’s enough cash value in your policy. And because there’s no hard inquiry into your credit, applying won’t affect your credit score.
Some creditors will only extend you a loan if you put up some kind of asset, like your house, as collateral. However, if you fail to make loan payments on time, the asset could be repossessed. By taking out a life insurance policy loan, the risk you incur is that you could lose your life insurance coverage. While that could leave your loved ones with a financial burden after you die, it may be better than losing your home in the short term.
If your life insurance has accumulated enough cash value, you may not need to pay as much out of pocket to repay your loan. If you feel confident you can make regular payments toward your debt or that your cash value can make up the difference, a life insurance loan is less of a risk.
Traditional loans from a bank or financial institution typically need to be paid back according to a schedule, usually by making monthly payments. Life insurance loans don’t have a repayment schedule, although failing to make any payments could result in a loss of coverage.
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While your permanent life policy is in force, you can use it to take out a loan, but that could reduce the death benefit or even cause the policy to lapse. Policy lapse is the biggest risk, but life insurance loans can also lead to diminished death benefits, among other concerns.
Depending on the insurer, you may need to keep your policy in force for several years before you’re allowed to use the cash value as collateral for a loan. And the cash value doesn’t always increase at the same rate, making it difficult to predict when you’ll be able to borrow against your policy and how much you can safely borrow.
With some types of life insurance, like universal life insurance, you may get no cash value increase at all, or even a decrease, if the market takes a dip. If your cash value never grows enough, you won’t be able to take out a life insurance loan.
If you don’t make your loan payments out of pocket, there are three components to your permanent life insurance policy that the insurer can use to collect payments:
The face value , which would normally be paid to your beneficiaries as a death benefit when you die. All life insurance policies have a face value.
The cash value , which replaces the face value over time and could eventually increase the amount of the death benefit. While your permanent life insurance usually gains cash value, in some cases the cash value may never increase the face value.
Dividends , which some insurers pay out when it costs less to insure you than predicted, that can be withdrawn as taxable income or used to pay your premiums and purchase additional coverage. While you may be eligible for dividends, they may be paid infrequently and are not guaranteed.
If you don’t make your payments, eventually there will be no death benefit left, and your policy will lapse.
To figure out if you can afford to pay back the loan, ask your insurer for a life insurance illustration. Also called an in-force illustration, this document will show how much you have to pay each month to stay on top of your loan.
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If you use up your permanent life insurance coverage to pay off a policy loan and your coverage lapses, the value of your depleted life insurance will be considered taxable income by the IRS.
For example: If your loan was for $100,000, and it gained $10,000 in interest during the time your policy’s cash value was keeping your policy in force, when the policy lapses you’ll receive a tax bill for the $110,000, minus any payments you made out of pocket. (Note that the death benefit itself is not taxed if you paid your premiums with your take-home pay.)
When you buy life insurance, you have the option to add an accelerated death benefit rider, which means that when you’re critically ill, you can use part of the death benefit to help pay for your care. However, if you have an unpaid policy loan balance, it may reduce the amount you’re allowed to receive from the accelerated death benefit.
Additionally, any unpaid loan balance could reduce the amount you’re owed in dividends, if you were otherwise eligible to receive any. That means you will have less money to withdraw from the policy if you just want straight cash. (Any dividends you use to pay back your loan could be subject to tax.)
Variable life insurance is another form of permanent life insurance, in which part of your premiums are placed in an investment account, and your cash value only increases when the return on investment is positive.
When you take out a policy loan using your variable life insurance policy as collateral, you may pay more interest than you would if you had a simple whole life insurance policy. That’s because you could be charged an opportunity cost , which is the difference between what your premiums were earning while invested and the amount you’re paying the insurer in interest payments.
If you’re concerned about the potential risks of borrowing against your policy, you might be better off surrendering your permanent policy, buying a term policy and borrowing through another institution, or purchasing a rider that protects your permanent policy from lapsing due to an unpaid loan.
Term life insurance is much cheaper than permanent life insurance for the same amount of coverage, but it also expires after a certain period, usually around retirement age. You also can’t use your term life insurance to take out a policy loan.
But because term life insurance is more affordable, you also save more money, which you could put toward paying off a loan from the bank. Keeping your life insurance and lending agreements separate also means you can’t lose your coverage because of your loan. This is the right option for most people.
Instead of taking out a life insurance loan, your insurer may allow you to surrender your policy after it’s been active for a certain number of years. This entails canceling your permanent policy, after which you would receive any accumulated cash value as actual cash, also known as the cash surrender value .
Note that the policy’s cash surrender value won’t be equivalent to the premiums you paid into it, so you may not get that much back from a cash surrender. Every insurer also imposes a small cash surrender fee, and you’ll need to replace the coverage you lost by surrendering your policy. If you have taken a policy loan, the cash surrender value will be reduced by the remaining balance on the loan.
If you’re set on a policy loan, some life insurers offer an overloan protection rider, which ensures that some part of your death benefit can’t be touched by the loan payments made out of your policy’s cash value so that the policy can’t lapse.
In most cases, the rider won’t take effect until you’re age 75 or older; and your policy must have been in force for 15 years. Your loan also may not be larger than a certain percentage of your policy’s value (the exact percentage depends on your provider), so it could take years to accumulate enough cash value to support the loan you need.
If you need a loan, it’s less complicated and less risky to apply at a bank or other financial institution than to borrow against your life insurance policy. Life insurance loans can introduce waiting periods before you’re able to borrow funds, tax implications, and jeopardize the most important benefit of your policy — the payout for your loved ones.
You can borrow against a permanent life insurance policy with a cash value. In this scenario, you’re not borrowing directly from your policy, but the policy is your collateral. You can also cash out a permanent policy, but doing so also leaves you without coverage. If you have term life insurance, you can’t take out a life insurance loan.
After your cash value grows to a certain amount (determined by your insurer), your insurer can issue you a loan. Loan terms and interest are set by the insurance company, and your provider will pull from your cash value — and eventually your policy’s death benefit — if you fail to repay your debt.
Policy loans are helpful if you wouldn’t be approved for a loan at another financial institution or you don’t want to risk other assets, like a house, by putting them up for collateral. However, it can take years for the cash value to grow to an amount from which you can borrow, borrowing comes with tax and interest payment implications, and failing to repay the loan puts your policy and thus your beneficiaries at risk.