Need cash fast? Your life insurance policy may allow you to borrow money through a loan. Before contacting your insurance carrier, first take a few minutes to learn how life insurance loans work, what they cost, and the potential pitfalls. This small effort now could spare you from unpleasant surprises later.
Read on for a walk-through of borrowing from life insurance, including the terms, tax consequences, borrowing limits, and the pros and cons. With that base of knowledge, you’ll be ready to decide if you should borrow money from your life insurance policy.
Can you borrow money from your life insurance?
Permanent life insurance allows policyholders to borrow money from their policy by using the cash value as collateral for a loan with no requirements. The base loan is not taxable and the policyholder can choose to pay it back whenever they want. However, life insurance loans accumulate interest and if it’s not repaid, the policy may default which can result in a loss of coverage, the cash value, and a large tax bill.
What types of life insurance can I borrow from?
You can borrow from any permanent life insurance policy that has cash value, including whole life insurance, universal life insurance, and variable life insurance.
When premiums are paid to maintain these policies, part of the money goes towards the cash value which is separate than the death benefit. A policy’s cash value is like a savings account that grows as you deposit money through premiums and interest that’s earned over time. Similar to a savings account, policyholders can choose to withdraw or borrow money from the cash value.
How much can I borrow from my life insurance policy?
Most insurers will allow you to borrow up to 90% of your policy’s cash value, and the minimum threshold will depend on your insurer (some may even have no minimum amount). The amount you can borrow depends on how much you have in your account. A policyholder with a cash value of $10,000 can borrow up to $9,000 while a policyholder with a cash value of $100,000 can borrow up to $90,000.
The amount you can borrow is determined by the cash value of your policy, but you aren’t actually taking money from this account. Instead, you’re taking a loan from the insurance company and using the cash value as collateral. By doing so, the cash value can continue to grow from interest as you pay off the loan separately.
How to borrow from a life insurance policy
Borrowing against your life insurance is easy. Typically, you just contact your insurer and ask for a loan. There will be no application or credit check. Because the insurer has the policy’s cash value as collateral, the process can be informal. You might need to confirm your identity, sign a document, or allow your loan request to be recorded on a call — but it won’t be more complicated than that. After the insurer receives the loan request, the money will be deposited in your account or you’ll receive a check within a few days.
Terms for a life insurance loan
Low interest
The interest rate for a life insurance rate is usually low, often much less than what you’d see with credit card debt or an unsecured personal loan. Most life insurance loans have an annual interest rate between 6-8%.
Flexible repayment schedule
Life insurance loans offer a lot of options for repayment, including letting the policyholder choose their repayment schedule. Because the loan is backed by the policy’s cash value, it’s a low risk transaction for the insurer and they won’t require payments until the total balance (base loan plus interest) exceeds the policy’s cash value. However, once this occurs the policyholder will have to start making payments or risk defaulting on the loan resulting in a loss of insurance coverage, the cash value, and a tax bill from the IRS.
Tax consequences
A life insurance loan is not taxable unless the loan amount is greater than what you’ve paid in premiums. However — and this is important — the loan will become taxable if you surrender or lapse your coverage. Basically, if your policy is cancelled for any reason, the IRS treats your loan and the outstanding interest as ordinary, taxable income.
How to repay a life insurance loan
You can repay a life insurance loan anytime, even if you aren’t required to make payments until the total balance exceeds the cash value of your policy. However, once payments become required you should make consistent payments to prevent the loan from defaulting.
To repay the loan, you’ll have to ask your insurer for the repayment address and then set up automatic payments from your checking account. While the insurer should send you loan statements periodically, don’t expect to receive bills with payment stubs. You can choose how much to repay, but the interest compounds annually so it’s recommended to pay the interest plus part of the principal to lower the balance over time. If you just pay the interest, the principal will remain the same so you won’t pay off the loan.
Should I take a loan against my life insurance policy?
Only you can decide if a life insurance loan is the right solution. Consider your goals for your life insurance, now and in the future, as you review the pros and cons below.
Pros
- Life insurance loans are quick. You should have the funds within a week.
- Life insurance loans don’t require credit checks. Your insurer won’t care — or charge you a higher interest rate — if your credit score dropped last week. The loan also won’t show up on your credit report.
- Life insurance loans don’t have to be repaid. The flexibility of a life insurance loan is an advantage if two factors are true. One, you must intend to keep paying your life insurance premiums indefinitely. And two, your relatives won’t need your full death benefit.
Cons
- Your loan will be taxable if your coverage ends. Once you accept the loan, you are committed to paying your policy premiums. Otherwise, your low-cost loan will get substantially more expensive when the IRS gets involved.
- The loan balance reduces your death benefit. You might think through how your beneficiary will be affected by the lower death benefit. This factor becomes irrelevant, though, if you pay off the loan while you are living.
- Life insurance loans don’t have to be repaid. The lack of repayment requirements is a disadvantage in two scenarios. One, you can’t afford your premium payments. And two, your relatives need your full death benefit.
Alternatives to borrowing against life insurance
Life insurance loans are quick and easy, but they do lock you into those premium payments indefinitely. That could be a dealbreaker if you expect your current cash flow crunch to be ongoing. Fortunately, there are two alternative strategies for raising cash from your life insurance. You can either sell your insurance in a life settlement or surrender it back to the insurer. Both would eliminate your future premium payments entirely.
1. Life settlement
In a life settlement, you sell your life insurance to a third-party investor for cash. The transaction takes a few months to complete, but you will net far more cash than what’s available to you via a policy loan. Sales prices can range from 20% to 60% of the policy’s death benefit.
Once the transaction closes, the new policy owner will control the death benefit and the cash value. That owner will also pay the policy premiums going forward.
You may be eligible for a life settlement if you are at least 65 years old and your policy value is $50,000 or more. If you’re considering this route, reach out to Harbor Life Settlements for a free policy review and estimate.
2. Policy surrender
You could also surrender your policy back to the insurer. This would cancel your coverage and death benefit immediately. As part of that cancellation, the insurer would close out your cash value account and send you a check for the balance, less any surrender fees.
Surrendering your policy makes the most sense when you’re too young for a life settlement and you can’t afford to keep the policy in force. This is because a life settlement can generate two to four times more cash than a surrender. That difference can add up to tens of thousands of dollars. If you aren’t quite 65, the potential for a larger life settlement payout may convince you to keep your life insurance for a few years until you can sell it.
To learn more about life settlements and to find out what your policy might be worth, contact Harbor Life Settlements today. Our team is happy to review your coverage, answer your questions, and help you identify how to generate maximum cash from your life insurance policy.
