A life insurance policy is a great way to get cash when you need it. You can borrow against the cash value of your policy and use the money for any purpose. There are no loan requirements or qualifications, and you can pay the loan back whenever you want.
Life insurance policy loans have relatively low-interest rates, making them a great option when you need extra cash.
Assuming you can keep up with your payments, taking out a loan against your life insurance policy is an easy way to access cash. However, defaulting on paying back this loan and the interest could result in a reduction of the death benefit if you were to die with an outstanding loan balance.
In some cases, you could even end up losing your life insurance coverage.
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What Types of Life Insurance Policies Can You Borrow From?
Most permanent life insurance policies offer the opportunity to borrow money from the cash value.
Permanent life insurance (including whole life, universal life and variable life) is designed to provide coverage for your lifetime.
Permanent life policies build cash value as you pay the premiums. The cash value portion of the policy either earns interest or is tied to an investment account or index, allowing you to grow the money over time.
Term life insurance, by comparison, is not life insurance you can borrow from. Term life insurance is a fairly low-cost insurance option designed to protect people during the years they need it most, such as the working years until their mortgage is paid off. These policies do not have a cash value component.
How Does a Life Insurance Policy Loan Work?
Policy loans come in the form of direct loans or indirect automatic premium loans, according to Barry Flagg, founder of Veralytic, an independent life insurance analytics company.
Direct loans
With a direct loan, you essentially borrow money from yourself, with the policy’s cash value serving as collateral. For this reason, you don’t have to pay income tax on the money you take out. The insurance company will also charge interest (called a spread).
Flagg explains that you essentially pay the interest back to yourself, less a spread charged by the insurance company. Usually, this can be as little as 0.25% (even 0% in some cases) or as much as 2%.
“Choosing a policy with a low loan spread can make a big difference,” Flagg says. “Either way, policy loans reduce both the policy account value and the death benefit by the amount of the loan on a dollar-for-dollar basis.”
If you pay the policy loan before you pass away, there is no deduction from the death benefit.
Automatic premium loans
An automatic premium loan (APL) allows the insurer to use your cash value to pay your life insurance premiums, if you don’t.
“While insurers generally send notice of such automatic premium loans, consumers don’t often understand the implications,” Flagg says. “So this type of policy loan can unwittingly accumulate for years.”
Flagg says that interest is also added to the balance, often at unfavorable rates. So when policyholders aren’t aware of these implications, APLs can grow quite large, eroding the cash value and causing a policy lapse.
How Does a Life Insurance Loan Affect Your Policy?
Before taking out a policy loan, contact your insurance company to find out how the loan will affect the components of your policy. You can do this by requesting an in-force policy illustration, which shows how the policy’s performance will be impacted if you borrow money, pay back the loan or maintain the loan.
The in-force illustration should also show whether interest is paid out of pocket or borrowed. The insurance company will either charge interest in advance (up front for the full year) or in arrears (at the end of the policy year).
How Much Money Can You Borrow Against a Life Insurance Policy?
Loans are available on life insurance policies when there is enough cash value. The amount you can borrow is represented as a percentage of the cash value. Each life insurance company has rules about how much policyholders can borrow, but Flagg says it’s usually around 90% to 95%.
Using those percentages, if your policy cash value is $50,000, you may be able to borrow $45,000 to $47,500.
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EPIA inc. is a private Insurance Agency with no ties with legal entities. The information contained in this article is based on information provided by the Medicare Official Website.