Introduction
Life insurance is mainly intended to provide money to beneficiaries if the policyholder dies. Yet, much life insurance also has living benefits that policyholders can use while they are alive. Being able to borrow money against the policy’s cash value is one such benefit. When this happens, it is called a policy loan. It’s important to know how policy loans work for anyone who is contemplating this financial tool
In this in-depth guide you will discover what a policy loan is how it works the kinds of insurance policies that permit borrowing and the possible benefits and drawbacks of utilizing this financial instrument. We will also explore when it may be appropriate to consider a policy loan and how to do so successfully
What Is a Policy Loan
A policy loan is a loan you can borrow from your life insurance company by leveraging the cash value of your permanent life insurance policy as collateral. Not all life insurance policies provide for this. It is usually available with permanent life insurance policies like whole life or universal life policies that accumulate cash value over time
In contrast to traditional loans, a policy loan does not require a credit check or proof of income. The insurer borrows you money against your own cash value and you are not borrowing from some outside financial company. Because the money is yours to start with the approval process is usually swift and easy
How Policy Loans Work
When you pay premiums on a permanent life insurance policy part of the payment is allocated towards creating cash value. The cash value increases over time using a guaranteed interest rate or investment returns based on the policy type. After the cash value accumulates to an adequate amount you can borrow some of it
Insurance companies typically permit policyholders to borrow eighty to ninety percent of the cash value. The loan is not taxable income as long as the policy is in force and does not expire. You can use the loan proceeds for any purpose such as personal expenses emergency or investment opportunities
The loan is not a fixed repayment loan. You can repay it as you wish. But if the loan is not repaid the outstanding amount plus interest will be deducted from the death benefit paid to your beneficiaries at your death
Types of Insurance Policies That Permit Loans
Not all life insurance policies have the facility to borrow against them. Whether you can take a loan or not depends mostly on the policy you have
Whole Life Insurance
Whole life insurance provides lifetime coverage with guaranteed increases in cash value. It is the most popular policy that permits policy loans. The cash value earns at a fixed rate as established by the insurer
Universal Life Insurance
Universal life insurance provides flexibility regarding premiums and death benefits. It also builds cash value although the rate of growth can differ based on market performance or the interest credited by the insurer
Variable Life Insurance
This kind of insurance enables you to invest the cash value in some investment options like stocks or bonds. The cash value growth relies on the performance of these investments. Policy loans are available but are riskier because of market volatility
Indexed Universal Life Insurance
This kind of loan associates the cash value appreciation with a market index like the S and P five hundred. It provides growth potential with some protection against market decline. Loans are available from the cash value but the amount of availability is contingent on the performance of the underlying index
Key Features of a Policy Loan
Quick Approval
Because you are lending against your own funds approval is virtually instantaneous. Most insurance companies fund loans in a matter of days
No Effect on Credit Score
No credit check is required and the loan is not reported to credit bureaus. This means your credit score is not affected whether the loan is approved or not
No Limitations on Use
The amount of the loan may be used for any purpose such as medical expenses education home repairs or travel. There are no reporting requirements or restrictions on use of the funds
No Required Repayment Schedule
Unlike conventional loans you do not have to pay back the loan in monthly installments. You have the freedom to decide when and how you will repay the loan or even choose not to repay it at all. Nevertheless interest will still accumulate
Lower Interest Rates
Policy loans tend to have lower interest rates compared to credit cards or personal loans. This is why they are a preferred choice for individuals who require access to low-cost funds
Benefits of Borrowing Against Life Insurance
Quick Access to Money
Policy loans are best suited for cases where you require immediate access to cash without having to go through lengthy application procedures or credit approvals
No Tax Implications
Provided the policy continues to be active and in effect and not allowed to lapse the funds that you borrow are not taxable income
Preserves Ownership of Policy
Borrowing never cancels out your policy nor affects your coverage. You retain ownership of the policy and are still covered by its original provisions
No Pressure to Repay
You are not required to pay regular premiums. This is beneficial during uncertain finances or variable income
Drawbacks of Policy Loans
Accruled Interest
The loan amount rises over time with accrued interest. If the interest is not regularly paid it accumulates and is added to the total loan amount
Lowered Death Benefit
Any loan balance plus interest is deducted from the death benefit. This decreases the amount your beneficiaries get upon your death
Risk of Policy Lapse
If the loan balance plus interest is more than the policy’s cash value the policy can lapse. This can leave you without insurance protection and can also lead to tax implications
Impact on Long Term Policy Performance
If you don’t pay back the loan it can restrict the future development of the cash value and trim the total advantages of the policy in the long term
When Is It Worth Using a Policy Loan
Policy loans must be well thought out and used ideally in certain circumstances where other means are constrained or unattractive
Short Term Financial Requirements
A policy loan is ideally suited for short term expenses or for unexpected costs like car repairs or medical bills
Lower Cost Borrowing
If you require a loan and are not eligible for low cost credit a policy loan is a less expensive option
Temporary Income Loss
If you are temporarily short of income a policy loan can be a buffer until your condition stabilizes
Strategic Investment Opportunities
A few individuals use policy loans for investment purposes anticipating that the gain will exceed the interest cost. But this is a risk and needs to be done with proper analysis
Alternatives to Policy Loans
Before borrowing against a policy it is worth investigating other options for borrowing that might be more cost effective for you
Personal Loans
Banks and credit unions provide personal loans which occasionally have competitive interest rates especially when you have good credit
Home Equity Loans
If you are a homeowner you should be able to borrow against the equity at a fairly low rate of interest
Retirement Account Loans
There are some retirement accounts such as a four zero one k which permit loans. These must be repaid after a specific period and can affect your retirement funds if not taken care of properly
How to Manage a Policy Loan
Monitor the Loan Regularly
Keep an eye on the loan balance and interest to ensure it does not grow beyond your ability to repay
Make Interest Payments
If you choose not to repay the loan balance at once consider making regular interest payments to prevent it from compounding
Review Your Policy Annually
Speak with your insurer to go through how the loan is impacting your policy and death benefit. Alter your approach if necessary
Speak with Beneficiaries
Notify your beneficiaries of the loan’s presence so they will not be surprised in the future when they receive a lower death benefit
Closing Remarks
Taking a loan against your life insurance policy can be an effective and smart financial move when utilized wisely. It provides fast access to money without the encumbrance of credit checks or strict payment schedules. Yet it is not risk-free. Accrued interest lowered death benefits and policy lapse are serious issues that have to be addressed with caution
Prior to taking out a policy loan consider your long term needs and goals and other funding options. Discuss with a financial planner or insurance professional to ensure that the loan supports your broader financial plan
When applied with a solid plan and prudent management a policy loan can be a useful source of money without compromising the original intent of your life insurance policy, which is to leave security for your loved ones.
