If you have a cash-value form of life insurance, such as whole-life or variable-life, your premiums contain an investment component that builds cash value over time. The primary purpose of cash value is to provide income in retirement – however, it can also be used as collateral to secure a loan prior to retirement.
Life insurance loans have some significant advantages. There is no credit check involved, since you are effectively providing collateral with your policy. With most companies, it is simply a matter of filling out a form and receiving your money within several business days. There are no restrictions on what you can use the loan for, as there can be with conventional loans.
Repayment schedules are flexible – if you like, you can pay a large sum one month and nothing the next. Of course, if you pay nothing, interest is still accruing on the loan.
That point can trip up people who mistakenly believe that they are borrowing their own money. You are providing collateral, just as with a home equity loan – thus, you are borrowing money from the insurance company, not from yourself. Interest is involved just as it is with any loan. That interest is added to the loan balance, being further compounded and eating away at the cash value without regular payments to replenish it.
Eventually, you could reach a point where the loan balance equals your total cash-value – at which point, your policy would be terminated and the remaining cash value used to pay off the loan balance. If that weren’t bad enough, you will be taxed on the gains you received over the premiums you paid, even though those gains were consumed in paying off the loan. You get a tax bill but receive no benefits to pay it with – you used them up with the loan.
Remember that if you die prior to repayment, the loan is repaid out of the death benefits component of your policy. You do not want to shortchange your death benefits to the point where the policy is not useful to your beneficiaries should you die. Choose any loan amount wisely.
If you have a whole-life policy, things are a bit more straightforward, because the investment component is predictable through guaranteed accumulation of cash value. Universal and variable life policies allow you to invest some portion of the cash value in different vehicles. You may make money or lose money from those investments, making your cash value less predictable. This makes the accounting of your cash value all the more important – if you are losing cash value, it aggravates the effects of not repaying your loan regularly.
There may be other costs associated with the loan that are less obvious. For example, a variable life policy may charge an “opportunity cost” associated with switching funds from the higher-returning investment account to the lower-returning guaranteed account to cover your loan collateral. Loans against a universal or variable policy may also include complicated tax ramifications.
While it is a relatively convenient approach, borrowing against your insurance policy is not always the smartest way to proceed financially. It is best to consult a financial advisor to help identify your options and answer any policy, loan mechanics, or tax questions you may have. Feel free to ask your question on MoneyTips, and an expert will answer free of charge!
If you do decide to borrow against your policy, treat it like any other loan and pay it off regularly. You can save yourself potential aggravation and expensive surprises just by following that simple rule.
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