When you bought your permanent life insurance policy, whether it be whole life insurance or universal life insurance, you probably chose it over a term life policy. People often make that choice because permanent life policies have a savings/investment component that grows over time. It’s called “cash value.”
Cash Value Life Insurance vs. Term Life Insurance
The big difference between cash value life insurance and term life insurance is that a term life policy will pay out only if you die during the specified policy term (such as 10,20, or 30 years), while a cash value life insurance policy pays a death benefit no matter when you pass away.
Also, term life insurance has no savings component to it; it’s purely life insurance. With a cash value policy, if the cash value is sufficient, you can use it to:
- Buy more life insurance coverage to increase the death benefit
- Pay your premiums
- Withdraw cash from the policy (if not repaid, the death benefit will be reduced)
- Take a loan from the policy using the cash value as collateral.
Some life insurance agents advise their clients to save money by buying a term life insurance policy and investing the difference in premium in a traditional investment, like a mutual fund. Unless done as an IRA or other tax-favored investment, the interest or investment profit is taxable, whereas it’s not in a whole life policy.
How Does a Policy Loan Work?
When you borrow money from your life insurance policy’s cash value, you’re not actually taking it from your life insurance. Technically, the insurance company is extending you the loan, using your cash value as collateral.
To some degree, you’re borrowing your own money. It’s an advance of money you could have received by either surrendering the policy or having the death benefit paid out to your beneficiary.
If you don’t pay back the policy loan while you’re living, the outstanding loan amount is deducted from the death benefit, which means your beneficiaries are repaying the loan for you.
As with almost all loans, the insurance company will charge you interest on the borrowed cash value. They either charge it in advance or arrears:
Interest in advance – the insurer charges you interest for the full year. They assume that you’ll continue having an outstanding balance for that policy year (which is not necessarily a calendar year). If you take out the loan halfway through a policy year, interest is only charged for the remainder of that policy year. The downside with interest in advance: if you repay the loan during the policy year, you won’t receive a refund or credit from the insurance company on the interest you paid in advance.
Interest in arrears – this can be much more equitable for the policyowner. With interest in arrears, interest accumulates daily. The day you take out the policy loan is the day interest starts to accumulate. If you repay the loan during the policy year, the daily loan interest rate decreases, which decreases the loan interest you owe at the end of the policy year.
Loans on a policy are similar to a mortgage loan – the interest rate can be fixed or variable. Fixed interest rates suit a more conservative individual because the rate is guaranteed. Other people prefer a variable rate that can change every year because it may be lower than when they took out the loan.
The variable interest rate you’re paying is disclosed on your life insurance policy’s annual statement and on notices you receive when loan interest is due.
The cash value you’ve borrowed can still earn interest. The insurer will pay you interest (or dividends on a whole life policy) on the amount of money you borrowed. The interest rate credited to your loan is usually lower than the interest rate credited to the remaining cash value in your policy. Some life insurance companies will pay the same interest rate.
Whole life insurance policies can also have an “automatic premium loan provision” written into your policy. If you fail to pay your premium, it is deducted automatically from your cash value through a policy loan.
Generally, you can’t deduct the interest you pay on a policy loan on your tax return.
How You Repay a Policy Loan
It’s important to know when you borrow money from your cash value; the life insurance company will not require you to pay back the outstanding loan balance and the accrued interest. They won’t provide you with a loan repayment schedule of any kind.
They will give you the option annually to pay your loan interest out-of-pocket or to have the loan interest be part of your policy loan. If you decide to borrow the interest from your cash value, the loan balance compounds, meaning the interest you owe year will compound. In other words, you’re paying interest on your interest.
When you borrow money from your cash value, the life insurance company will provide you with an “in-force policy illustration” every year if you request it. It will help you see the impact your loan is having on your policy.
When you make your request for the illustration, ask to include the following scenarios within the illustration to see the financial impact on you if you:
- Repay the loan in-full
- Pay premiums and interest out-of-pocket
- Borrow future premiums and interest on the loan
- Want to see what happens if your premium payments remain the same
- Want to know the premium amount needed to endow the policy when it matures
- Take a partial withdrawal or change your dividend option
A huge benefit of the in-force policy illustration is that it will show you how long your policy will remain in force due to borrowing from your cash value.
To put it simply, when you borrow money from a cash value life insurance policy, you repay the loan IF you want to, WHEN you want to. But remember, having a loan balance when you die means the death benefit is reduced by the amount of the policy loan outstanding, meaning your beneficiaries will receive less money.
Pros vs. Cons of Life Insurance Policy Loans
Borrowing from the cash value of a life insurance policy is a matter of preference – some people are comfortable with it, and some aren’t. These are the pros and cons (advantages and disadvantages) of a life insurance policy loan.
- No credit check, no questions asked. When borrowing from your cash value, you don’t need to complete an application, like you must when borrowing from a bank or credit union. You simply fill out one form, and you’ll receive your payment. And, unlike a credit card, a cash value loan doesn’t appear on your credit report.
- Low-interest rates. In most cases, policy loans are charged a lower interest rate than bank loans or credit cards. Personal loans from a bank average anywhere from 10% to 28%, and the average interest rate for a credit card is 18.24%. The interest rate you’re charged on cash value policy loans will range from roughly 5% to 8 percent on a fixed interest rate loan.
- No required timetable for repayment. A cash value policy loan can be repaid, or not repaid, according to your schedule and ability to pay it back. There is no requirement that you pay back the loan. The outstanding loan amount when you die will be deducted from your policy’s death benefit,
Any time you can quickly and easily get a loan, there are drawbacks, and cash value loans are no exception.
- Not enough cash value to borrow. The cash value in a permanent life insurance policy builds up slowly. It may be many years before there is enough cash value to fund a meaningful loan. In the early years of the policy, you’ll see little, if any, cash to borrow.
- Reduced payout. If you don’t repay the money you borrowed during your lifetime, the death benefit will be reduced. This may harm your survivors financially.
- Risk of losing coverage. Even though you can borrow from your cash value life insurance policy at a low-interest rate, you’re still going to pay interest on your life insurance loan. Choosing to have the interest subtracted from the policy’s cash value can cause the cash value balance to deplete quicker than you might think. If your loan and the interest end up exceeding your policy’s cash value, your life insurance policy could lapse.
- Tax consequences. You could have a tax liability with a policy loan if your policy lapses before you paid back some of the loan.
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Alternatives to a Policy Loan
If the disadvantages of taking out a policy loan have you feeling uneasy, there are alternatives to borrowing from your cash value.
- Buy term life insurance. Term life insurance is much less expensive than permanent policies that build cash value, but you can’t take out a policy loan with a term policy. The money you save by buying a term policy could be put toward paying off a bank loan, and you won’t risk losing your coverage because the loan and interest caused the policy to lapse.
- Surrender your policy. Instead of borrowing from your cash value, you could “cash out your policy.” Technically, you could “surrender” it after it’s been active for a certain number of years. When you surrender your policy, you’ll receive the accumulated cash value in the policy, which will be less than the premiums you paid into it. When you surrender your policy, there will no longer be a death benefit paid to your survivors.
- Get the policy’s “overloan protection rider.” This rider will keep a portion of your death benefit from being put at risk by loan payments from your policy’s cash value. This guarantees the policy won’t lapse. With most policies, the rider won’t take effect until you turn age 75 or older, and the policy will have to be in force for more than 15 years.
The Life Settlement Option
It’s much less complicated and less risky if you take out a loan from your bank or other financial institution than if you borrow from your life insurance policy. Borrowing from your cash value has waiting periods, possible adverse tax consequences and puts the primary reason you bought the policy at risk: the death benefit for your loved ones.
As opposed to having your policy lapse or surrendering it to the life insurance company, a viable option is the life settlement. With a life settlement, you work with a life settlement company that finds a buyer for your life insurance policy. You won’t need to take out a bank loan, and you won’t lose everything you’ve paid because your policy lapsed.
The life settlement industry is highly regulated, and thousands of people take advantage of this option every year. They no longer need the death benefit and would rather sell their life insurance policy than pay for a death benefit they don’t need, plus pay interest on a loan and put their policy at risk.
A viatical settlement works much like a life settlement, though the insured must be diagnosed as having a life expectancy of fewer than two years or have a chronic illness.
Selling a term life insurance policy is not an option with a life settlement, but the term policy can be converted to a permanent policy and then sold.
Questions and Answers
How do I take out a loan from my policy?
It’s an easy process. Contact your life insurance agent or the insurer and ask them for the form you need to take out a policy loan.
How much can I borrow from my policy?
The amount you can borrow will vary from insurer to insurer, but a loan of 90% of the cash value is typically the maximum amount you can borrow from your life insurance policy. There is no minimum amount.
How likely is my policy to lapse if I take out a policy loan?
If your repayment stretches over many years, you’re going to be facing compounding interest. Depending on the percentage of the cash value you borrow, the total of the outstanding loan could end up exceeding the cash value life insurance policy’s cash value, which would result in the policy lapsing and becoming worthless.
How much can I get for my policy if I sell it through a life settlement broker or viatical settlement broker?
The amount you’ll receive from selling your life insurance policy will depend on the policy’s face amount, your age, and your life expectancy. A life settlement company can provide you with an informed estimate of what you’ll receive for your policy.
How long does a life settlement take?
Selling your policy can take 4-6 weeks from contacting the life settlement company until you receive your payment.
Don’t lose your lifelong investment. Discover your policy’s value today.