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What if you have an emergency and there are no savings in the bank?
Among many options, borrowing from your life insurance policy is an option to consider.
Wasn’t it one of the reasons why you bought it in the first place?
The Big Picture
Before you borrow from your policy, remember that there are several pitfalls against taking a loan. First, there’s the danger that you might forget to pay the loan interest and subsequently affect the death benefit adversely. Second, you might believe that dividends from your variable universal life insurance policy will be enough to settle the loan.
However, the biggest item that borrowers and even insurance agents fail to understand is the tax aspect of such loans. It is a complicated method that revolves inside a life insurance policy. It’s like you build a house on top of a hidden sinkhole. You are not aware that the sinkhole may swallow your house any moment.
You’ll probably be surprised to know that there could be better options. One is by opening a home equity line of credit (HELOC). Or sometimes, taking out a personal loan might be more to your advantage.
The Basics of Borrowing From Your Life Insurance Policy
You’ve probably decided to buy a type of life insurance partly because of its cash value feature. You’ve probably thought it was a good idea to have a ready source of quick cash in case you need it. If you are planning to borrow from your policy, pause and think carefully.
Does it really make sense to do it now under your circumstances?
A whole life insurance will cost you more in premiums but it won’t expire. The insurance coverage remains in effect as long as the insured is alive. The premiums may be higher but there’s benefit in it for you. The company invests the money you pay into the policy after they get what they need for the death benefits. This investment becomes the cash value of your policy after a few years.
In effect, the entire life insurance policy will have two values:
First, there’s the face value, which is essentially the death benefit. Second, there’s the cash value that technically acts as your savings account.
When the investment increases the amount of death benefit, you can then borrow from the tax-free cash value. When you take out a loan, you are not taking money out of your death benefit. You are borrowing from the insurance company and using your policy as collateral for the loan.
Another benefit is that the loan does not affect your credit score and does not need an elaborate approval process. It does not even need a credit check before the company approves it. This is easier than getting a bank loan or a credit card because you are merely borrowing your own money.
When you borrow against your policy, you don’t have to explain what it is for. It means you can use it for anything – pay your bills, buy a sports car or travel to the Himalayas. Furthermore, the IRS will not treat the loan proceeds as income so it is tax-free.
Understand The Policy Conditions
Like any other loan, you have to pay it back with the corresponding interest. The bonus is that the interest rate is much lower than for a bank loan or a credit card. The company will not require a regular monthly payment. This may be good or bad for you depending on your preference.
Of course, you need to pay back the loan in a timely manner. Even with a low interest and flexible payment schemes, make sure you pay it back. If you don’t make regular out-of-pocket payments, they will add the interest to the balance.
Interest continues to accrue whether you pay the bill monthly or not. If you let it accrue, you will risk letting the accrued interest exceed the policy’s cash value. This may cause your policy to lapse. Insurance companies want the policies to remain active. They give borrowers many opportunities to keep the loans current and avoid lapsing.
Use a Simulation
In case you let the policy lapse, you will have to pay taxes on the cash value. If the borrower does not pay back the loan before the insured person’s death, it will affect the death benefits. The insurance company will deduct the outstanding loan principal and all accrued interest before they release the proceeds.
Before you actually borrow, it would be good to ask your agent to do an “in-force illustration.” This simulation will show you exactly how your loan will affect your policy. Also, check out your other options and weigh the advantages and disadvantages of borrowing against your policy.
Borrowing From Your Life Insurance Policy vs. Borrowing From A Bank
Many people buy a life insurance with values for the primary purpose of building assets. They know that later on in life, they can borrow against the insurance or use the investment when needed.
- Some borrow from the life insurance to avoid the hassle of borrowing from a bank. There are people who want to repay the loan within a reasonable period. They also do not want interest to accumulate so they want to pay the interest on time. Borrowing from the life insurance is therefore most convenient for them.
- If the intended amount of the loan is less than the cash value, this option is for you. This assumes that you have the means to pay back both principal and interest within a considerable time. Of course, you should have the intention of doing so. Your agent can help run the numbers for you.
- Borrowing from your life insurance policy will give you more flexibility in repayment. A bank will always require you to make regular payments for a fixed period. A life insurance policy loan will have no fixed payment requirements. You can pay as little or as big as you want at any time interval you desire. However, always be careful how your payment (or non-payment) will impact your policy. Compare how the loan principal and interests are stacking up against the cash value of your policy. If you only need a small or a short-term loan, this would really help. You can get money quickly and pay it back on your terms.
Don’t Borrow Trouble
Follow these strategies when borrowing from your policy:
- Consider borrowing from your policy as a last resort. Borrow only if you need cash for vital needs. Do not borrow for non-essentials such as a cruise, or a new TV or your daughter’s wedding. If you really, badly need cash but it’s not possible or practical to get another type of loan, go ahead. Borrowing against your policy is quick and the interest rate is very reasonable.
- Never borrow the maximum amount. Just because you can borrow 90% of the amount of the cash value means you should borrow all of it. Instead, borrow a smaller portion. That lessens the risk that your loan balance will exceed your cash balance.
- Pay the interest each year. Do not ignore the interest. If you pay the interest, you prevent the loan balance from growing. This keeps your death benefits intact for your beneficiary.
- Check the statements from your insurance company carefully. Monitor your loan balance. If your loan balance exceeds the cash value, pay quickly to make up for the deficiency. This will protect you from a huge tax bill.
Remember The Consequences Of Borrowing From Your Life Insurance Policy
By now, you already have a basic knowledge about borrowing against your life insurance policy. This could be your take-off point when you discuss with your financial advisor so you could make an intelligent decision. If you manage your borrowing smartly, it will be to your advantage. On the opposite end, you’ll expose yourself to financial dangers if you borrow without careful planning.
Risks Example: Creditor Protection:
The cash value in your insurance policy enjoys protection from your creditors so they can’t touch it. However, the law treats the loan from your policy as cash and therefore is not protected against your creditors. If you borrowed from your policy because of hard times, you may end up in a harder financial situation.
Before taking out a loan, you must have a good grasp of the big picture. It is not the same as withdrawing money from your savings account. The loan is a much more complicated transaction with a lot of implications. So, make sure you understand everything about it, before you decide to borrow.
Is There A Better Option Than Borrowing Against Your Life Insurance Policy?
The answer to this question will depend on the situation. In some cases, you may find a better option that may even have lower cost. For example, nothing looks more attractive than a tax-deductible Home Equity Line Of Credit (HELOC). And with today’s rates in the vicinity of 3%, that is hard to beat.
Yes, there are fees and interests involved in borrowing against real estate. Lenders are even charging humongous pre-payment fees for short-term borrowers. It has also become more difficult to apply for such loans since the real estate crash. Both borrower and the property must comply with the lending requirements. There should be sufficient equity and a steady job with an income many times over the debt payment. Of course, the borrower must have a good credit score.
Borrow From Retirement
If you borrow from or take money from retirement accounts, you open yourself to fees and taxes. Some company restrictions also bar you from borrowing against your retirement account – even from your 401k. This restriction also applies to emergency situations. On the few occasions they let you borrow, they will impose some conditions on you. They will only lend you whichever is lower between $50K or 50% of the vested funds. I
If you aren’t borrowing money for down payment for a house, you need to pay the loan within 5 years. Another major issue is that you’ll have to repay the borrowed funds with after-tax dollars. These will be again subject to tax at withdrawal unless it is a Roth account.
IRA’s are even more uncompromising. Lenders do not accept them as collateral. You can only access your funds for a 60-day period. Experts consider this a ‘tax-free rollover’ and that period is inflexible. Beyond the 60 days, you will have to pay income taxes plus a penalty. You will also lose the ability to return the money to your IRA.