Collateral assignment of life insurance is an agreement that gives a lender first claim to collect an outstanding loan balance from your life insurance death benefit. That allows your life insurance to serve as the collateral that many loans — especially small business loans or Small Business Administration (SBA) loans — require as part of giving you the money.
In other words, your life insurance death benefit becomes the property that ensures that the lender can collect the loan value if you die before the loan is paid off. After the loan is repaid, any remaining death benefit funds go to your beneficiaries.
How collateral assignment works
Collateral assignment, unlike credit life insurance, lets you name beneficiaries you choose instead of having the lender be the sole beneficiary. You can use either a term life or a permanent life insurance policy for collateral assignment.
If your current life insurance policy is worth more than the loan, you may be able to use it as collateral. In other cases, loan companies that take life insurance as collateral may require you to buy a new policy that covers at least the full amount due.
Either way, the process of getting a policy is the same. You go through the application and underwriting process, and wait to receive your offer. Then, you complete paperwork to set up a collateral assignment.
Once you’ve paid off the loan, you get a release from the lender. The collateral assignment condition on your policy ends, but the policy can stay active.
Whom to name as your beneficiary
When buying life insurance for collateral assignment, name the beneficiaries as you would for a personal policy (e.g., spouse, relative, trust for children). The lender is not your beneficiary; they are the assignee on the collateral assignment paperwork. You are the assignor.
A collateral assignment supersedes your beneficiaries’ rights to the death benefit. If you die, the life insurance company pays the lender, or assignee, the loan balance. As noted earlier, any remaining benefit goes to your beneficiaries.
Who owns the life insurance policy
You’re the policy owner and the payor — which means you’re 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’re using a permanent life insurance policy for the collateral assignment, a lender may have access to the cash value if you default on the loan.
When to fill out collateral assignment paperwork
You only complete a collateral assignment agreement once a life insurance policy is active. After you pay your first premium, and sign your policy papers, you can request 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.
Once completed and signed by both the assignee and the assignor, you’ll file the collateral assignment form with the life insurance company and the lender according to whichever procedures they use for this process.
When collateral assignment ends
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 to terminate the agreement.
If your policy lapses — or you choose to cancel it — that could violate your loan contract. The lender 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.
Collateral assignment pros & cons
Collateral assignment of life insurance has clear pros and cons. Review the following list carefully to decide if it’s a good option for you.
Collateral assignment pros:
It enables people to secure business loans or similar needed funds.
It’s less risky for a family than using a home or other essential property as collateral.
Policyholders can choose beneficiaries to receive any remaining death benefit funds.
Downsides of collateral assignment:
The lender has first right to the death benefit, so your family may not get the benefit you intended.
Lapsing or canceling the policy could violate your business loan terms, causing problems with the lender.
You’re responsible for paying life insurance premiums.
Alternatives to collateral assignment
Other ways to use a life insurance policy for debt repayment include the following options.
Life insurance loan: If you own a permanent life insurance policy, a life insurance loan allows you to borrow directly from your policy’s cash value. Any unpaid balance, plus interest, is deducted from your death benefit.
Cash surrender: The cash surrender value is the cash value built up in the policy minus administrative fees. Surrendering your policy cancels your coverage, so you’d need another policy for continued financial protection. You could also face penalties if you cancel during your policy’s surrender period.
Term life insurance: You should always buy enough insurance to cover your debts. On average, term life is five to 15 times cheaper than whole life. Even if your lender doesn’t require collateral, your beneficiaries can use the death benefit to pay off your debts and keep the remainder.
For most people, term life is the most affordable and straightforward option to provide coverage for any outstanding loans when they 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.