Updated November 3, 2021|3 min read
When you apply for a loan, particularly a small business loan or Small Business Administration (SBA) loan, you can use your life insurance coverage as collateral. This is called collateral assignment, and it ensures that your lender will be paid any outstanding loan amount if you don't have a good credit rating or other collateral.
Collateral assignment is different from naming the bank as the sole beneficiary of your policy, like with credit life insurance. Instead, collateral assignment ensures that if you die before repaying your loan, the insurance company will use your death benefit to settle up. After that, any remaining funds go to your named beneficiaries.
If you already have a policy with a death benefit greater than your loan amount, you may be able to collaterally assign that policy. However, some lenders may require you to buy a new policy specifically for collateral assignment. If you don’t have a life insurance policy or need additional coverage, you will need to apply for a separate policy. Once you have a policy in place, you can request collateral assignment paperwork from your insurer.
Collateral assignment makes your life insurance death benefit collateral for a loan
If you die before repaying your debt, your insurer pays back what you owe to the lender before disbursing funds to your beneficiaries
You complete collateral assignment forms after your policy is active
The agreement ends only after you’ve satisfied the terms of your loan
Applying for life insurance for collateral assignment is the same as applying for a personal life insurance policy — you need to have an active personal policy before you can assign it as collateral. You’ll go through the application review and underwriting process, and wait to receive your offer.
When buying life insurance for the purpose of collateral assignment, you name the beneficiaries as you would for a personal policy. So, if your personal policy would list your spouse, you list your spouse. The lender is not your beneficiary; they are the assignee on the collateral assignment paperwork after your policy is active. On the form, you are the assignor.
When you fill out a collateral assignment form, that assignment supersedes your beneficiaries’ rights to the death benefit. If you die, the life insurance company pays the lender, or assignee, the loan balance. The remainder of your death benefit — if there is one — goes to your beneficiaries.
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You are the policy owner and responsible for the premium payments. Some lenders may require an escrow account for the life insurance premiums, others may require proof of payment or prepayment. If you use a whole life policy for collateral assignment, the lender has access to the cash value of the policy if you default on the loan.
After you pay your first premium, sign your policy papers, and the insurer confirms that your policy is active, then you can ask for a collateral assignment form from the life insurance company or your insurance broker.
You’ll need your loan officer’s name and number for the form, as well as your policy number, Social Security number, and other personal information.
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Collateral assignment ends only if you pay off your loan before you pass away. Your lender must agree that the terms of your loan have been met and send a release to your insurer in order to terminate the agreement.
If your policy lapses or you choose to cancel it, the lender could consider that a violation of your loan contract. They may even pay your premiums on your behalf to prevent a policy lapse. In that scenario, the lender adds the cost of any premiums they paid for your policy to your loan total.
If your lender doesn’t require a collateral assignment agreement but you want to leverage your life insurance for debt repayment, there are a few other options.
Life insurance loan: A life insurance loan allows you to borrow directly from your permanent policy’s cash value. You need to accumulate enough cash value to cover a loan, which can take several years. Any unpaid amount, plus interest, is deducted from your death benefit.
Cash surrender: You can give up your permanent policy and take its cash surrender value, the amount of cash built up in the policy minus administrative fees. This option involves canceling your policy, so you’ll need to find replacement coverage and could face penalties if you cancel during your policy’s surrender period.
Term life insurance: You should always buy enough insurance to account for your debts. On average, term life is five to 15 times cheaper than whole life, and your beneficiaries can use the death benefit to pay off your debts and keep the remainder, sidestepping collateral assignment paperwork or lender involvement.
For most people, the most affordable and straightforward option is using your term life insurance policy’s death benefit to account for any outstanding loans when you die, with or without a collateral assignment attached. If you need to use your life insurance policy for collateral assignment, the process is as simple as buying a policy and filling out the appropriate paperwork.
A collateral assignment of life insurance directs your insurance provider to use your death benefit to pay off an existing loan if you die while in debt. After the lender is paid, any remaining funds go to your policy’s beneficiaries.
Your lender is the assignee of your collateral assignment agreement. You are the assignor of the agreement and the owner of your life insurance policy.
Collateral assignment can only be revoked if your lender confirms that your debt is paid and sends a release of collateral assignment to your insurer. The assignment cannot be changed if you change your mind or if your life insurance policy lapses.