Life insurance loan policy
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Many people purchase life insurance to financially provide for their family members after their death. But some life insurance policies allow the policyholder to take out money while they’re still alive in the form of a loan. Life insurance loans have advantages, but it’s not the right choice for everyone. We’re going to discuss life insurance policy loans, how they work and how to determine if it’s a good option for you.
What is a policy loan?
A life insurance loan is money that you borrow from your life insurance policy. It is similar to a traditional personal loan in some ways, but life insurance policy loans are only available with life insurance policies that have a cash value component. Cash value is commonly found with permanent life insurance policies.
When you take a life loan, also called a loan on life insurance, the policy loan money can be used for anything. You can use the funds to pay for a child’s college tuition, make a down payment on a new home or pay for other financial obligations. Usually, the money can be accessed quickly and is often used to pay for emergency expenses.
How do life insurance policy loans work?
Permanent life insurance policies have two parts—a death benefit and cash value. When you pay the monthly premium, some of the money goes toward the death benefit and some goes into the cash value. Depending on the type of policy, the cash value can grow with interest or it might be invested in the stock market.
When you have enough cash value, you are allowed to take out a life insurance loan. But unlike a personal loan, there is no approval process for a life loan and it will not affect your credit. As long as you have adequate cash value funds, you are allowed to borrow money, tax-free, for any purpose. Best of all, you aren’t required to repay the loan.
However, there are certain caveats with life insurance loans. Some insurance companies have guidelines dictating when a policyholder can start borrowing money and how much money can be borrowed at one time. For example, your policy might need to be in force for 10 years before you can borrow any money, regardless of how much cash value you’ve accumulated.
If you never take out a life insurance loan, your beneficiaries will receive the death benefit plus the cash value of your policy after you pass away. Borrowing against the cash value means that your beneficiaries will receive a lower death benefit unless you repay the loan in full while you are still living.
How to monitor a life insurance policy loan
Unlike a personal loan, life insurance policy loans need to be monitored over time. If you don’t keep tabs on the policy, you could end up losing the minimum cash value needed to maintain coverage and the policy could lapse.
Here’s why: Policyholders pay interest on their life insurance loan. The interest is usually deducted from the cash value. With permanent life insurance policies, monthly premiums are often paid for out of the cash value. Over time, the loan interest could diminish your cash value to the point that it no longer covers your monthly premium. You might have no choice but to make hefty loan repayments, and it could also lead to higher income taxes.
To monitor a life insurance policy loan, keep an eye on your cash value balance. It’s also a good idea to request an in-force illustration from your insurance company to see how you can expect your loan to impact your policy based on certain actions.
Pros and cons of life insurance policy loans
- Won’t impact your credit score
- No formal application or approval process
- Interest rates are typically low
- Loan doesn’t need to be repaid
- May need to meet certain requirements before you can borrow
- Death benefit lowers if you don’t repay the loan
- Could lose coverage without accurate monitoring
Loan on life insurance can be a great way to get some extra cash. There is no formal application process, the money can be used for anything and borrowing the money will not affect your credit score. And with low interest rates, a life loan might be a cheaper option than taking out a regular personal loan.
One of the biggest upsides to life insurance policy loans is that you don’t actually have to repay the loan. So if you’re in a tough financial situation, there is no pressure to repay the loan over a certain period of time. Just know that if you decide to not repay the loan, the money you owe will be taken out of the policy’s death benefit.
However, there are drawbacks to life policy loans as well. You may need to meet certain requirements before you can borrow against your cash value. And once you do, you’ll need to monitor your policy closely and consider paying back the loan if you want to retain your original death benefit amount.
How can a life insurance policy loan be dangerous?
Despite the benefits of a loan against a life insurance policy, it can also be a dangerous move, especially if you’re not planning to repay the loan. When you take out a life insurance loan, the money accumulates interest over time. And when you fail to repay the loan, the interest compounds and grows twice as fast.
If you plan to use the remaining cash value reserve to pay the interest, it can quickly deplete the money in the account. And remember that your cash value often pays for more than just the loan. It might cover your monthly premiums, mortality fee and policy administration fees. If your cash value runs out, you risk losing coverage unless you start making out-of-pocket payments.
Having your policy cancelled is bad enough. But if your policy is terminated, you will have to pay higher income taxes on the loan money you borrowed. Without careful planning and loan monitoring, your loan could end up costing a significant amount of money.
How to calculate taxable income from a life insurance policy loan
It’s a good idea to calculate the taxable income from your life insurance policy loan to see how it could affect your taxes. Here is the basic formula:
- Add the policy surrender value, plus dividends (if applicable) and the outstanding balance on the loan.
- Next, take the first number and subtract the cost basis, which is the sum of premiums you have paid so far. If you’re unsure of the cost basis, your insurance company can give you the number.
- The remaining number is the estimated taxable income for your loan. Remember that life insurance loans are not taxable unless the loan value is greater than the amount of money paid in premiums over the lifetime of the policy.
- Life insurance loans offer quick cash without a formal application or approval process
- Most life insurance companies have restrictions around how much money can be borrowed
- Life loans are not taxable as income as long as the policy stays in-force
- Life insurance loans have risks and they are not a good option for everyone
Life insurance loans can seem like an easy way to get money quickly, but there are downsides to be aware of. Before taking out a life insurance loan, ask your insurance company about the requirements and request an in-force illustration to gauge how the loan could affect your policy. You can also talk to a tax professional to figure out how a life insurance loan could impact your taxable income, and if it’s a smart option financially.