Understanding Life Insurance Loans

If you need money in an emergency, one place to look is your insurance policy. That is, if what you have is permanent life insurance  – available as either “whole life” and “universal life”.

Unlike term life insurance, which has a set time limit on its coverage period and does not accumulate cash value, universal life does have a cash component, especially later on. "In the early years of the policy, most of the premium goes to funding the indemnity benefit. As the policy matures, cash value increases," says Luke Brown, a retired insurance lawyer. 

How Much, How Soon

As cash value builds in a whole or universal life insurance policy, policy holders can borrow against the accumulated funds. Life insurance policy loans have one distinct advantage: The money goes to your bank account tax-free. 

Insurers generally make no promises as to how fast or to what extent the cash value will increase.  So it’s hard to know exactly when your policy will be eligible for a loan. What's more, insurers have varying guidelines outlining how much cash value a policy must have before you can borrow against it – and what percentage of cash value you can borrow.

Your policy is likely to have sufficient cash value to borrow against  "typically after the 10^th year the policy is in force.”

Something else to know: This loan isn't taking money from your own cash value. “You are actually borrowing from the insurance company and using your policy’s cash value as collateral,” says Reich.

No Need to Repay

One attractive aspect of loans against cash value is that you don't have to repay them – a huge benefit in an emergency.

If you do pay back all or a portion of the loan, options include periodic payments of principal with annual payments of interest, paying annual interest only or deducting interest from the cash value. “Loans have an interest rate like any other type of loan. It tends to be in the 7% to 8% range, which is high in our current environment," says Reich. Interest will be fixed or variable, depending on your policy.

There is a good reason to repay the loan if you can. “If the loan is not paid back before death, the insurance company will reduce the face amount of the insurance policy when the claim is paid,” says Ted Bernstein, CEO, Life Insurance Concepts, Inc..

The accumulated interest can cut deeply into the benefit: “If the policy loan remains outstanding for many years, the amount of the loan grows and grows due to the added interest,” Brown cautions. “That puts the policy at risk of not providing beneficiaries any money upon the death of the insured.

“At the very least, interest payments should be made so that the policy loan does not effectively grow,” Brown adds. That gives you a better shot of having money left to pay out after your death.

When Life Insurance Loans Make Sense

Here are some financial situations when a life insurance loan might be a sensible choice:

• You can’t qualify for a standard loan or need cash really, really fast. Because the money is already within the policy and immediately available, it's a quick source of immediate funds for a new furnace, medical bills or another emergency, with no credit check required. Even if you qualify for a traditional loan from a bank or credit union, a life insurance loan could be a valuable stopgap if you t don’t have time to wait for your application to be processed. When the traditional loan comes through, immediately use it to repay the life insurance loan.
• You can’t afford your policy’s annual premium. Don’t let a life insurance policy lapse because you can’t afford the payment.  A loan can keep the policy in effect as long as the death benefit is greater than the amount of the loan.
• Your only other loan options have much high interest rates. Before paying a higher interest rate for a loan or pledging additional collateral for a traditional loan, consider taking out a life insurance policy loan, says Bernstein. “Since there are no loan terms such as repayment dates, renewal dates or other fees, compared to traditional loans, life insurance policy loans can be very competitive,” he says.

The Bottom Line

Choosing if and when a life insurance loan is right for you is subjective, Reich says. “You have to look at which is more important; the immediate need for the cash or your family’s need for the death benefit. Understand that any outstanding policy loans will be deducted from the death benefit, resulting in a smaller benefit for your family."

Before borrowing against your life insurance, it may be helpful to consult a financial advisor to weigh all possible options and outcomes based on your financial portfolio.

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