Traditionally, people buy life insurance to provide money for their beneficiaries in the event of income loss after death. However, life insurance products have evolved and integrated a savings or investment component into the policy. As a result, certain types of life insurance allow you to take out a loan against the policy.
While borrowing against life insurance policy during financial emergencies can be helpful, it’s important to understand the specifics beforehand. Many policyholders who borrow carelessly end up jeopardizing their life insurance policy.
To help you avoid that, we’ve put together some essential points to remember before borrowing against life insurance policy. Read on to find out if borrowing from your policy is a good idea for you.
How Does Borrowing Against Life Insurance Policy Work?
Borrowing against life insurance policy works differently from getting a traditional loan. The application process is easier compared to traditional borrowing. However, you must check the eligibility of your policy. Not all insurance policies include a loan provision.
Typically, you can borrow against your life insurance policy once you’ve built up the cash value. Since term life insurance doesn’t have cash value and expires at the end of the term without earning returns, they don’t allow you to borrow money from the policy.
On the other hand, whole life and universal life insurance are among the policies that provide cash values. As far as the non-term plans go, you may take out a loan if you’ve paid premiums promptly for no less than three years. Remember that you’re using your policy’s cash value as collateral for the loan, and the amount you can borrow depends on the provider.
Although the majority of life insurance companies allow their policyholders to take out loans up to 90 percent of the policy’s cash value, ensure to check the amount you’re eligible for.
What Happens When You Borrow Against Your Life Insurance?
Taking out a loan against your life insurance seems like a good idea when you need fast cash during emergencies. But like other types of loans, it comes with both advantages and disadvantages. Before taking this option, it’d help to understand what happens when you borrow against your policy.
Below are some of the possible outcomes worth considering if you intend to make an informed decision:
Payback Is Open-Ended
Unlike traditional loans, insurers don’t establish a repayment schedule for the money you borrowed from your policy. It’s up to you how and when you’ll pay back the loan. In fact, you are not required to repay it. But note that there are interest charges on the amount you borrowed. Often, insurers bill the interest annually on your premium renewal date.
If you decide to pay only the interest, the principal amount due will be deducted from the claim amount at the time of settlement. But if you pay back the principal and interest during the policy term, you’d restore the total amount of death benefit and end the accrual of interest charges.
Loan Is Not Taxable
The money you borrow against your policy is usually not taxable, provided that the amount is equal to or less than the sum of the premiums you have paid at policy termination. Since you’re using your cash value as collateral, the cash remains in your policy and still earns investment income even if it’s an outstanding loan. So, your money will continue to grow tax-deferred in your policy.
No Credit Impact
Loans taken out from your insurance policy are a private matter and don’t appear on your credit report. There’s no credit check, application, or qualification necessary to get approved as long as your policy has a loan provision and has already built up its cash value. So you can borrow against your policy any time, for any reason, without any impact on your credit.
Reduced Death Benefit
Borrowing against life insurance policy can affect the death benefit your beneficiaries receive. The only way to avoid this is to pay the interest charges and the principal amount before anything happens to you. But suppose you unexpectedly die before your policy loan is paid. In that case, the loan’s entire balance and the unpaid accrued interest will be deducted from the death benefit intended for your beneficiaries.
Hefty Tax Bills On Policy Lapse
The interest rate on a policy loan is usually low. However, it can snowball if you don’t pay it back as soon as possible. That’s why it is always good to pay more than the premiums to cover what you’ve borrowed. Otherwise, the interest will compound and be added to your loan balance, which may exceed the cash value of your policy.
If that happens, the policy will lapse, and you could end up paying a hefty tax bill. Remember that the money you borrow isn’t taxable only if your policy stays in place. But once you’re forced to surrender the policy, it’s then treated as income and not tax-free.
Should You Use Your Insurance Policy To Take Out A Loan?
Although using your insurance policy to take out a loan can be risky, it can be reasonable in certain situations. Make sure you understand the possible consequences before deciding on anything.
A policy loan might be worth considering if you don’t qualify for a standard loan. It’s hard to get approved for a traditional loan, especially if you have bad credit. Since there’s no credit check with a policy loan, you can get the funds you need as long as your policy has already built enough cash value.
If you need a flexible repayment schedule, borrowing against your insurance policy might be a good idea. This is because you’re not required to make monthly repayments. However, it could result in a loss of coverage if you delay payments. But if you can guarantee paying the interest and principal amount, this option might be beneficial for your situation.
The decision to use your insurance policy to take out a loan is entirely up to you. But it would be best to look at possible alternatives before going for this option. While this can be an excellent solution for emergencies, it may not be worth the risk in every situation. Remember that borrowing against life insurance policy is a complex transaction. Make sure you clearly understand every aspect of it.