Borrowing against your life insurance policy can provide access to funds during times of financial need without having to liquidate investments or tap into retirement savings. Also known as a policy loan, it allows you to leverage the cash value that has accumulated in permanent life insurance policies like whole life and universal life. With interest rates typically lower than other financing options, policy loans offer borrowers a way to access capital with relative ease.
However, like any loan, borrowing against your policy does come with some risks and downsides to consider before moving forward. This article will provide an in-depth look at how borrowing against your life insurance works, outline step-by-step instructions for taking out a loan, key factors to weigh, tips for borrowing responsibly, alternatives to consider, and summarizing the pros and cons of this approach to financing.
What Types of Life Insurance Policies Allow You to Borrow?
The first thing to understand is that policy loans are only available on permanent cash value life insurance policies – not term life insurance. Some examples include:
- Whole life insurance – Offers lifelong coverage along with a cash value account funded by a portion of premium dollars. This provides strong borrowing and growth potential over time.
- Universal life insurance – Also provides lifelong coverage and cash value growth. Some universal policies offer more flexible premium and death benefit options.
- Indexed universal life insurance – Links cash value accumulation to a market index while also guaranteeing a minimum rate of return. This can optimize growth potential.
Term life insurance only pays out a death benefit and does not build cash value, so it does not allow policyholders to borrow against it.
Additionally, most insurers will require you to have contributed premiums for a certain number of years before you become eligible to take a policy loan. This ensures your policy has sufficient cash reserves set aside first.
Step-by-Step: How Does Borrowing Against a Life Insurance Policy Work?
If you have a qualifying permanent life insurance policy in place, follow these key steps to take out a loan:
1. Contact Your Insurer
Reach out to your life insurance provider’s customer service or loan department. Ask them to explain factors like:
- Loan terms & rates – What is the current interest rate charged on policy loans? Does this vary over time?
- Maximum loan amount – Insurers often set loan caps at 90-95% of the cash value to ensure some funds remain in the policy.
- Outstanding loan limits – Does the insurer limit the total amount you can borrow at any given time?
- Repayment rules – What repayment schedule is allowed or required? How will unpaid interest be handled?
Having clarity on these details is crucial before moving to the next steps.
2. Review Your Policy Performance
Next, thoroughly review your most recent annual policy statement. Pay attention to:
- Cash value accumulation – The current cash value is the maximum that can be borrowed. Be sure there are sufficient reserves.
- Death benefit – Review if and how an outstanding loan balance reduces the payout your beneficiaries would receive.
- Dividends or interest earnings – Loans may impact the returns your cash value would otherwise earn. Weigh this opportunity cost.
If your policy is not meeting original projections, borrowing may exacerbate underperformance.
3. Submit a Policy Loan Application
You will need to complete a loan application form issued directly from your insurance provider. Be prepared to provide:
- Personal details
- Policy account numbers
- The loan amount requested
- How funds will be delivered (check, wire transfer, etc)
Many insurers allow online or over-the-phone loan applications for convenience.
4. Receive Loan Proceeds
If approved, loan funds disburse within a few business days in most cases. You immediately gain access to these proceeds with no restrictions on how the money gets used.
With the loan now active, regular interest charges will begin accruing based on the insurer’s policy loan rate.
Key Factors to Consider Before Borrowing
Before initiating the loan process, several variables are worth careful evaluation:
Interest Rates and Terms
Most policy loan rates currently fall around 5-8%, considerably more favorable than higher rates associated with personal loans or credit cards. And unlike bank loans, you have flexibility in repayment – no strict monthly installment or deadline. However, unpaid interest gets added to the loan balance, increasing what is owed over time.
Impact on Policy Performance
An active loan slightly alters how your policy operates:
- Cash value may continue earning interest but generally at a lower credited rate compared to when no loan exists. Slowed growth potential is the tradeoff.
- Failure to repay the loan or interest due can eventually reduce the death benefit payout your beneficiaries would receive if you pass away before the loan gets fully repaid.
- If the total loan balance exceeds the cash surrender value at any point, the policy risks terminating. This can lead to adverse tax consequences.
Be realistic about your ability to handle loan repayment before borrowing. Integrating automatic payments can help.
Tax Implications
One main advantage of borrowing from a permanent life insurance policy is that generally no taxes apply – even on interest paid towards the loan. However, there are exceptions:
- If the policy terminates with an outstanding loan balance still due, the amount in excess of your premiums paid becomes taxable as ordinary income.
- Certain policies have a “direct recognition” provision forcing loans over a certain threshold to be immediately taxed.
Consulting a tax professional can clarify the rules around your specific situation. But otherwise, policy loans receive beneficial tax treatment.
Tips for Borrowing Responsibly Against Your Policy
If you move forward with a loan, adopt habits and strategies to repay smoothly:
- Set up automatic payments towards interest charges, even if paying down principal must wait. This prevents unpaid interest from accruing rapidly.
- Commit to a repayment schedule with targets to reach over time as your situation allows. Treat repayments like any recurring bill.
- Monitor your policy annually – the impact that loans have on cash value growth and death benefit size may shift each year.
- Have a backup plan if unable to make payments for an extended stretch, such as setting aside cash reserves in case the insurer requires immediate repayment in full of the balance.
Proactively managing policy loans instills discipline around repayment which helps prevent policy disruption down the road.
Alternatives to Borrowing Against Your Life Insurance
If borrowing does not align with your strategy or comfort level, a few other options exist:
Policy Withdrawal
You can make a direct withdrawal from your policy’s cash value instead of taking a loan. The amount withdrawn technically gets taxed as ordinary income. But often policyholders have enough tax basis to offset taxation, especially on smaller sums. This avoids paying any interest.
Downsides are reduced cash value and death benefit, plus potential surrender charges on withdrawals coming early after policy initiation.
Policy Surrender
Alternatively, you can cash out the policy entirely. This terminates your coverage but pays out the cash surrender value – the current cash value minus any surrender fees. Taxes still apply on gains.
Surrendering can make sense if you no longer need life insurance coverage. But it forfeits future growth potential and typically involves high transaction fees.
Other Funding Sources
Personal loans, 401(k) loans, home equity lines of credit, or credit cards could provide borrowing alternatives depending on your financial profile. Weigh factors like rates/fees, tax implications, risk, and loan amounts when comparing funding sources.
Key Takeaways: Is Borrowing Against Life Insurance Right for You?
Deciding whether to borrow against your policy is an individualized choice. But focusing on these key questions helps frame the decision:
- What are your plans to repay the loan? Can you commit to a repayment schedule? Failing to repay may risk policy termination and surrender charges.
- How will borrowing impact policy performance? Be conservative when projecting future cash value growth and death benefits with an active loan.
- Are alternatives like withdrawals or surrender better options? In some cases, the flexibility of borrowing gets outweighed by other options.
- Could other financing sources better fit this situation? Weigh how policy loans compare against personal loans, 401(k) loans, home equity, and more.
Diligently weighing these considerations allows for an informed decision about whether borrowing aligns with your financial situation. While policy loans have unique advantages, they still must get managed responsibly once initiated.
Conclusion
During times of financial need, borrowing against permanent life insurance policies can certainly help bridge funding gaps without pursuing high-interest rate options. Policy loans provide a way to access capital, often at rates around 5-8%, using the cash value within your whole life, universal life, or indexed life insurance coverage as collateral.
But the decision to borrow merits careful evaluation of both the short and long-term impacts on your policy’s performance and health. With prudent planning guided by the factors outlined here, policyowners can strategically utilize this asset as a supplemental funding stream, while safeguarding its ability to function as protective coverage for years to come.