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Life insurance is an important tool to protect your loved ones from financial distress in the event of your death.
Life insurance offers more than just a death benefit. You can borrow money from life insurance if you have insurance with cash value. Cash value life insurance is one of the most convenient and low cost financing options. However, there are also pitfalls to avoid when using this method.
What kind of life insurance can I borrow?
Most whole life insurance policies offer the opportunity to borrow money from cash value.
Whole life insurance increases in cash value as premiums are paid. The cash value portion of the policy earns interest or is tied to an investment account or index, allowing you to grow your money over time.
term insurance, by comparison, is not life insurance that you can borrow. Term life insurance is a fairly low-cost insurance option designed to protect people during the time they need it most, such as years of service before their mortgage is paid off. These policies do not have a cash value component.
How do life insurance policy loans work?
Policy loans come in the form of direct loans or indirect automated premium loans, said Barry Flagg, founder of Veralytic, an independent analytics firm for life insurance companies.
A direct loan essentially borrows money from you against the cash value of the policy. For this reason, you do not have to pay income tax on the money you withdraw. Insurance companies also charge interest (called spreads).
Flagg explains that you basically pay yourself the interest, after deducting the spread that insurance companies charge. Typically this is as little as 0.25% (and sometimes 0%), or up to 2%.
“Choosing a policy with low loan spreads can make a big difference,” Frag says. “Either way, policy loans reduce both the value of the policy account and the death benefit by the amount of the loan per dollar.”
There is no deduction from the death benefit if the policy is paid before the death of the insured.
automatic premium loan
Automated Premium Loans (APLs) allow insurance companies to pay for life insurance premiums using cash value.
“Insurers typically send out notices about automated premium loans like this, but consumers often don’t understand what they mean,” Flagg said. “So this kind of policy lending can unwittingly accumulate over the years.”
Interest is also added to balances, often at unfavorable rates, Flagg said. As a result, if policyholders are unaware of these effects, APL can become very large, cash value lost and policies lapsed.
How does a life insurance loan affect your policy?
Before taking a policy loan, contact your insurance company to find out how the loan affects policy components. To do this, Illustrated shareholding policywhich shows how policy performance is affected when you borrow money, repay a loan, or keep a loan.
A valid diagram should also indicate whether the interest is due out-of-pocket or borrowed. Insurance companies charge interest either upfront (one year advance) or in arrears (end of policy year).
How much money can I borrow for a life insurance policy?
Loans are available with life insurance policies if there is sufficient cash value. The amount that can be borrowed is expressed as a percentage of the cash value. Each life insurance company has rules on how much a policyholder can borrow, but usually about 90% to 95% for him, Frag said.
Using these percentages, if your policy has a cash value of $50,000, you may be able to borrow between $45,000 and $47,500.
How to repay a life insurance loan?
Unlike most types of loans, life insurance policy loans do not have a specific repayment period. You can take as many as you like.
However, holding funds indefinitely can have negative consequences as interest accumulates. Therefore, if you borrow against the policy, we recommend that you repay the loan in a timely manner.
Policy loans can be repaid in one of three ways.
Ideally, you would be repaying the loan with a cash payment to the life insurance company. “Paying back in cash increases both the value of the policy and the death benefit by the amount paid back per dollar,” he says.
Frag said insurance loans can be repaid with “excess” cash value if the costs charged on the policy can be reduced and the cash value is sufficient to cover the reduced costs. However, it warns that if the loan repayment amount is greater than the policy fee/tax base amount, repayment in this manner may be taxable.
If there is a loan balance remaining on the policy at the time of death, the loan balance will be deducted from the death benefit. Your beneficiary will receive a reduced profit. Still, Frag says paying off an insurance company loan this way is the most tax-efficient way to pay back, because the death benefit is received tax-free (either with taxed cash or with It does not withdraw surplus cash value that may be taxable). ).
What if I can’t pay off my life insurance loan?
If you don’t repay the loan on the insurance policy or don’t make any payments on the interest, the interest will be compounded and added to your balance. If this continues long enough, the amount borrowed may exceed the cash value of the policy and the policy may expire.
“The full amount of the loan is then taxable as virtual income,” Flagg says. This is taxable income, he explains, that has no actual cash income to pay taxes. The loan balance is also taxed at the normal income tax rate, not at the more favorable capital gains tax rate.
If you die before paying off the loan balance, the insurance company will deduct it from your death benefit. So the beneficiary will receive less money and basically repay the loan on your behalf.
Pros and cons of borrowing money from life insurance
Consider these pros and cons before borrowing money from life insurance.
- No credit check required: Since you are borrowing your own money, there is no formal credit check required to qualify for a policy loan.
- Low interest rate: A policy loan is a low-interest financing option. Interest rates range from approximately 5% to 8%, depending on whether they are fixed or variable.
- Pay back when you need it. There is no formal repayment deadline, so you can pay according to your balance according to your budget and cash flow.
- Cash value continues to grow: The cash value of the policy simply acts as collateral, so the funds continue to stay in the policy and earn interest.
- Minimum cash value required: You must have sufficient cash value before taking out a loan. So if the policy is fairly new, it can take years to build decent cash value.
- Borrowing limit: You can only borrow up to a certain percentage of the cash value. So if you need to borrow more, you should consider other (potentially more expensive) financing options.
- Decrease in death benefits: If not repaid by the time of death, it will be deducted from the beneficiary’s death benefit.
- Expiration risk: You don’t have to repay the loan according to a set schedule, but interest continues to accrue and insurance companies continue to charge policy costs. If the loan balance exceeds the cash value of the insurance, the insurance may expire. This means you have to inject premium money to keep it active.
Alternative ways to borrow money from life insurance
A life insurance loan can be a convenient, low-interest loan if done right. However, if you want to avoid the risks associated with borrowing from life insurance, consider other ways to leverage cash value.
cash value withdrawal
Instead of borrowing money from life insurance, you can easily withdraw cash. As long as you withdraw up to the amount of premiums you have paid so far, you will not have to pay taxes on the funds. The downside is that withdrawing generally reduces your death benefit.
One of your options when you no longer need life insurance is cancel life insurance for cash. This is a good option if you no longer have children to support, or if you have a lot of debt and need cash in retirement. Please note that some policies charge a cancellation fee which reduces the amount you receive.
Compare life insurance companies
Compare policies from eight major insurance companies