Should You Borrow Against Your Insurance Policy?


 

Have you ever found yourself considering to borrow against your insurance?

You probably counted the loan feature of your insurance policy when you bought it.  Obviously, your choice fell on a policy that offered cash values and the possibility of getting a loan against the accumulated cash.

If you’re thinking of borrowing against your life insurance, first make sure that you are doing the right thing.

A whole life policy costs more but has no expiry date. The term coincides with the life of the insured.  Generally, the monthly premiums are more expensive. The insurer first allocates your payment to cover the death benefit costs.  They invest the excess amount to build up a cash value after a few years.

Over time, your policy will have two values

The first value is the face value, which is equal to the death benefit.  The second is the cash value, which acts as a savings account.

Once the invested money increases the amount of the death benefit, you can now borrow against the remaining cash value.  The insurance company will not take the policy loan out of the death benefit.  They are technically lending you the money and using the cash value as the collateral.

Borrowing Against Your Insurance Policy

Policy loans do not affect your credit rating the way a bank loan or credit card debt does.

There is also no stringent approval process required because you are essentially borrowing against yourself.  You are also not required to explain the purpose of the loan.  Therefore, you have a free hand to use the proceeds whether to pay your bills or go on a trip.  The loan proceed is also tax-free because the IRS does not treat it as your income.

However, since it is a loan, you have to pay it back with interest.  The good news is, the rate is much lower than a bank loan and there is no mandatory monthly payment.

Don’t Forget The Pay Back

Even with these easy terms, you must pay back the loan in a timely manner.  Preferably, you should pay the loan out of your pocket.  If you don’t, the insurance company will add and accrue interest. They will do this even if you religiously pay your monthly premium. In such case, you will risk making your loan bigger than the cash value, which may cause your policy to lapse.

Insurance companies normally give enough time and opportunity for borrowers to keep the policies current to avoid lapsing.  Should the policy lapses, you must pay taxes on the cash value.  If the loan remains outstanding during the death of the insured, the beneficiary will receive less.  The insurance company will deduct the loan and any accrued interest from the death benefit.

Benefits Of Borrowing From Your Life Insurance Policy

No Credit Check

If you have sufficient cash value, you can borrow against your policy.

You do not have to go through an application process the way you would do for a bank loan.  All you have to do is fill out a form and claim your loan proceeds.  It is that simple.  You do not have to worry about your credit score or provide a proof of income.  Again, this is because you are technically borrowing against your own money.  Cash value loans do not affect your credit report, unlike other loans or credit card debt.

Lower Interest Rate

Insurance policy loans bear interest.

However, compared to a bank loan, the rate is much lower for a cash value loan.  You even get more savings if you compare it with a credit card cash advance.  You just have to make payments each month to cover the interest or use your dividends to cover it.  This way, you can make your loan really beneficial for you.  This type of loan is really a lot cheaper than conventional loans.

No Pressure For Repayment

You can repay the life insurance loan at your own pace.

You do not have to follow a strict repayment schedule.Technically, you don’t have to pay back the loan but if you don’t you effectively decrease the death benefits.  The company will deduct all outstanding principal and interests before they pay your beneficiary.

Flexibility

Generally, you can borrow as much as 95% of the cash value of your whole life insurance.

When you take out a loan, you dictate most of the terms.  You can set how much you want to pay regularly – or irregularly. You can design your own repayment schedule according to your capacity to pay. You can modify it when your circumstances change.  Should things really turn bad, you can opt not to pay it at all.

Remember:

Of course, you already know how that will affect your death benefit.  In contrast, most types of non-insurance loans have very strict repayment requirements that may be burdensome to you.

Disadvantages Of Borrowing From Your Life Insurance Policy

Reducing Utilizable Assets

An inherent disadvantage of borrowing against your own asset is that you end up with fewer disposable assets.  You effectively lessen the opportunity to use it or to borrow against it.  Unless you’re borrowing to acquire a greater asset, you can scratch off your collateral asset for the moment.

Oh, did we forget to mention you needed to pay interest too?

Before you take a loan, you should make a thorough evaluation.

Do you really need it?

What if you just reduce your expenses instead of incurring more debt?  What other options are available? So before you borrow against your policy, talk to your financial advisor or agent.  It is important to see the overall impact that borrowing against your policy will have on your finances. Just because you can borrow against it does not mean you should.

Take note that some forms of insurance, such as Universal Life and Equity Indexed Universal Life (EIUL) operate differently. We will cover that in a different article.

Losing  “Emergency Cash” Value

Don’t forget that you took a life insurance policy so your family will have funds in case of your death.

If you borrow most of your cash value and do not pay the premiums on time, the policy may lapse. You therefore lose your coverage and your beneficiary will get nothing. It may also create some tax liabilities.

High Loan Balance 

Although the interest rate is quite low, it can also compound real quick.

If all you’re paying is the premium and nothing for the loan, accrued interest can build up.  It could inflate the loan balance beyond your policy’s value. If that happens, your policy will lapse.  The insurance company will ask you to surrender it and you will lose your coverage.

Tax Liability Exposure

An outstanding loan balance may start a “tax event” or an issuance of an IRS Form 1099. This will happen if you borrow more than what you’ve saved and cancel your policy later. The IRS has designated some ‘cash-rich’ policies as ‘modified endowment contracts‘ (MECs).In such case, if you borrow against a MEC, it becomes taxable.

If you suspect that your policy is a MEC, ask your agent about any tax consequence of a loan.  So, make sure that your insurer properly structures your policy to avoid this. Generally, the IRS does not treat the proceeds of the loan as income.

It becomes taxable if you surrender the policy. If you have cashed on a substantial amount of the equity value, you could be required to pay huge taxes.

Example

Scenario:

Jenny Moore, age 50,bought a permanent life insurance policy. After 10 years, she has made a total payment of $200,000 and accumulated a cash value of $240,000. This indicates that the $200,000 she paid earned an investment income of $40,000. Let’s say that Jenny decided then to take a $200,000 loan.

Points:

Technically, Jenny did not borrow from her policy.  Her insurance company lent her the money and used the policy’s cash value as her collateral.  From the cash value of $240,000, Jenny could have borrowed up to 90% of it or $216,000.  So, the $200,000 is below the loan limit amount. Jenny could use the loan proceeds in any way she wants.  The IRS will not tax Jenny for the money.

Downside:

The insurance company may charge interest that is at par to the yields on top corporate bonds. Assume that the loan rate is a compound 6% p.a. and Jenny chooses not to pay interest for 12 years. Effectively, her loan balance would go up to as high as $400,000.

Pitfall:

Jenny’s $240,000 cash value continues to earn money because it is like an investment account.  However, the earnings are significantly lower than if Jenny hadn’t borrowed any money.  The borrowed $200,000 will earn interest that’s 1%-2% lower than the rate of the rest of the cash value.

Result:

The loan balance will accumulate faster than the cash value. In this case, when the loan balance reaches $400,000, Jenny’s cash value will only be $380,000.

What Are Your Options?

If you’re not comfortable in risking your life insurance policy, you can look at other options for a short-term loan. If you are a homeowner, you can try a home equity loan or a line of credit. These loans usually have lower interest rates.  Of course, your lender will have to consider your income and credit history before you get an approval.

You might also borrow from your 401(k) or take an early withdrawal from your IRA.  If you borrow from your 401(k), you also pay interest on your loan.  What’s more, your employer will automatically deduct the payments from your paycheck.  If you want to quit your job before you have repaid your loan, you have to pay off the balance.  Otherwise, you will incur a tax penalty.

If you take money out of your IRA, you open yourself to some tax consequences. If you make a withdrawal before you are 59 & 1/2 years old, you have to pay income tax. On top of this, you will incur a 10% penalty.

The IRS will not tax-qualified distributions from a ROTH IRA but there may be early withdrawal penalty.  Before you take your money out of your nest egg, find out what it’s going to cost you.

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