Cost & Coverage
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You can use your permanent life insurance's cash value as collateral to take out a loan, but you could lose your life insurance coverage.
Permanent life insurance accrues cash value the longer you stay alive, kind of like equity you might gain on a home the longer you live there. After a certain period of time, you may be able to take out a loan from the life insurance company using your policy’s cash value as collateral.
Permanent life insurance, which includes whole life insurance, universal life insurance, and variable universal life insurance, is the only type of coverage that includes a cash-value component. If you need cash fast, you can take out a loan against your policy, but it comes with certain strings attached that might make it less cost-effective than simply getting a standard loan from your bank.
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 benefit when 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.
Read on to learn more about life insurance loans:
When you take out a life insurance loan, you’re not actually withdrawing from your life insurance. Instead, the insurer will be extending you the loan, using your cash value as collateral. There are a couple of reasons why you might want to do this.
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, so you could be approved for the loan as long as there’s enough cash value built up on your policy. What’s more, because there’s no hard inquiry into your credit, you won’t hurt your credit score even more.
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 only risk you incur is that you could lose your life insurance coverage. While that could leave your loved ones with an enormous financial burden after you die, it may be better than losing your home.
You need to pay back your life insurance loan, or you risk losing your coverage. However, if your life insurance has accumulated enough cash value, you may not need to pay as much.
Traditional loans from a bank or financial institution typically need to be paid back on schedule, usually by making monthly payments. Life insurance loans don’t have a repayment schedule, although failing to make timely payments could result in a loss of coverage.
If you’re looking for a life insurance policy that could also increase in value before you die, talk to a licensed insurance expert at Policygenius, who can help you compare quotes and understand how to get the most out of your life insurance coverage.
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If you have permanent life insurance, you’re covered until you die, as long as you’re still paying premiums or your policy is already paid up. While the 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. Beyond that, there are several other risks you take on when taking out a policy loan.
The cash-value component to your permanent life insurance policy isn’t the same thing as putting money in a savings account. Instead, it’s a representation of the value of keeping you on as a customer: the longer you pay premiums, the more valuable you are to the insurer. Because of that, the cash value doesn’t increase the face value of the policy for a long time.
Depending on the insurer, you may need to keep your policy in force for as long as 10 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. The insurer uses the cost of insurance plus its return on investments to determine how much your cash value will increase each year.
You might get a small increase one year and a larger increase in another, and with some types of life insurance, like universal life insurance, you may get no 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 payments toward the policy loan, the life insurance company will use the cash value to make loan payments. While that could be a seen as a benefit, eventually the cash value will deplete, and the insurer will start subtracting its payments from your death benefit.
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.
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 keep making payments:
If you don’t make your payments, eventually there will be no death benefit left, and your policy will lapse. All those years you spent paying premiums could be for nothing; you only got to use the part of the policy you extracted for the loan, and the rest of the policy, which could’ve been worth hundreds of thousands of dollars more, will have gone toward loan payments.
And there’s a good chance your policy could lapse, because…
As with other loans, your policy loan accrues interest. The exact rate at which interest accrues is decided by your insurer in advance. Often, this rate is lower than loans that you can get from your bank, but it could also be higher; it depends on the insurer and the policy.
Additionally, this interest compounds, meaning that, periodically, the unpaid portion of the interest gets added to your loan principal, and your interest rate is applied to that amount instead of the principal amount. Think of it like paying interest on your interest.
Compounding interest is not unique to life insurance loans – loans from financial institutions also use this method – but it something to keep in mind when trying to figure out whether you can afford the loan.
If you used up your permanent life insurance coverage to pay off our policy loan and your coverage lapsed, the value of your depleted life insurance will be considered taxable income by the IRS.
It works like this: say your cash value increases by a certain percentage rate every year, but the loan’s interest rate is more than twice as high. While the increasing cash value will stave off policy lapse for some time, eventually you’ll use the whole amount to pay off the loan.
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. This reduces the death benefit, but it may make your final years much more comfortable. 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.)
Life insurance loans are only a feature of permanent life insurance, like whole life and universal life. Variable life insurance is another form of permanent life insurance, where your premiums are invested 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.
Some life insurers offer an over-loan protection rider, which makes sure that some part of your death benefit can’t touched by the loan payments made out of your policy’s cash value, meaning that the policy won’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. You also need to have accumulated a cash value of at least a certain amount, usually $100,000.
Instead of taking out a life insurance loan, you may be able to withdraw cash from the policy directly. This is called cash surrender. If your insurer allows it, after a certain period of time, you may cancel the permanent life insurance policy and receive the accumulated cash value as actual cash.
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. You’ll also lose your coverage, although in some cases the cash surrender value can pay for a term life insurance policy to replace the coverage you’re losing.
If you have a policy loan, the cash-surrender value will be reduced by the remaining balance on the 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 of time, 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. That means if you have term and you need to take out a loan, you can borrow from the bank and use your savings to make loan payments. You’ll never run out of coverage (unless the term ends), and you could potentially save hundreds of dollars per year.
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