Life insurance is a financial tool that provides a death benefit to the named beneficiaries after your passing.
Many people do not realize that certain life insurance policies also can provide a source of cash while the insured is still alive.
Life insurance loans are one way to access the cash value of a life insurance policy.
In this article, we will explore how life insurance loans work and the benefits they can provide.
This article is written as general education, and should not be considered as personal financial advice. If you would like personal guidance with life insurance, you can schedule a time to talk with one of our experts.
What Is a Life Insurance Loan?
A life insurance loan is a loan that is taken out against the death benefit of a life insurance policy and secured by the current cash value.
The cash value is the amount of money accumulated in certain life insurance policies over time.
Life insurance loans are available from most insurance companies, and may sometimes also be available from third-party lenders.
How Do Life Insurance Loans Work?
The policyowner can take a loan for any purpose, such as paying off debt, covering medical expenses, or making a down payment on a home.
The loan does not have to be repaid immediately, and the policyholder can continue to make premium payments and/or loan payments on the policy while the loan is outstanding.
Suppose the insured dies before the loan is repaid. In this case, the amount of the loan plus interest will be deducted from the death benefit paid to the beneficiaries of the policy.
However, if the loan is repaid in full before the insured passes away, the beneficiaries will receive the full death benefit.
To take out a life insurance loan, the policyholder must first request a loan from the insurance company. Most companies allow you to do this online, via the phone, or by filling out paperwork.
The option is called a loan because the insurance company sets your cash value aside as collateral and provides you with the insurance company's money.
The loan amount cannot exceed the policy's cash value and caution should be used in taking loans which represents a large portion of the cash value, as this could cause the policy to lapse.
The interest rate charged on a life insurance policy loan is typically lower than what is offered by other types of loans, such as credit cards or personal loans, and the terms are specific to your contract.
What Are the Benefits of Life Insurance Loans?
There are several benefits to taking out a life insurance loan:
1. Competitive interest rates
The interest rate is typically lower than what is offered by other types of loans.
This can save the policyholder money in interest charges over the life of the loan.
2. The loan does not have to be repaid on a defined schedule
Life insurance loans does not have the same re-payment obligations as other types of loans might have, and does not technically need to be paid back until the death benefit is paid out to the beneficiaries.
This can provide the policyholder with a source of cash when needed, without having to sell assets.
3. The loan does not require a credit check or other collateral
The cash value and death benefit of the life insurance policy serves as collateral for the loan, so the policyholder does not have to put up any additional assets as collateral.
4. Loans on life insurance policies are tax-deferred
As long as the policy is not a MEC (learn more in this article), you will not pay ordinary federal income tax on loans unless the policy is surrendered or lapses, and there are gains.
5. Provides flexibility on loan payments and repayment
The policy owner can choose when and what to repay on the loan for the entire life of the policy, or can skip loan payments all together.
When skipping loan payments, it is important to understand that the policy may lapse if the loan balance outgrows the cash value, which would come with negative tax consequences.
To avoid this risk, many insurers offers riders called “Overloan protection”, which locks the policy when the loan balance becomes too large, which protects it from lapsing.
6. The loan does not have to be repaid if the insured dies
If there is an outstanding loan at death, the death benefit would be used to pay off the loan and any interest.
This also provides peace of mind to the policyowner, knowing their beneficiaries will not be burdened with the loan repayment.
The death benefit is generally not taxable as ordinary federal income (if there is a properly structured ownership and beneficiary arrangement), so the outstanding loan would also not be taxed.
7. Some life insurance policies offer a loan interest credit
This is a specific rate (outlined in your contract) that is paid back into the policies cash value by the insurance company and is based on the size of your outstanding loan.
It is important to note that any crediting is not applied directly to the loan but rather goes back into your cash value.
What Are the Risks of Life Insurance Loans?
Life insurance loans can provide many benefits but there are also risks.
1. The loan balance will reduce the death benefit paid to the beneficiaries
This means that the policyholder's loved ones will receive less money than they would have if the loan had not been taken out or was repaid in full.
2. Loans taken on some policies may negate guarantees until repaid in full
This could cause premium payments to have to increase or could put the policy in jeopardy of default.
3. Outstanding loans may be taxable if the policy is defined as a MEC
If the policy is considered a MEC by the IRS (learn more in this article), any gains received as a loan may be taxable.
Additionally, if a policy owner surrenders a policy or it was to lapse, loans received may be subject to taxation.
4. The loan may limit the investment performance of the cash value
When you take a loan, the part of the cash value that secures that loan may be re-allocated to a different account with lower potential growth.
For some participating whole life insurance policies, a loan could affect the non-guaranteed dividend that you would’ve otherwise received on your cash value.
This means that taking a loan may decrease the total potential growth of your cash value.
6. Any unpaid loan interest will accumulate on the outstanding loan
Like any other loan, a life insurance loan balance will grow if you’re not re-paying the interest amount, which impies a reduced death benefit amount.
As the loan grows, interest will be charged on the new, larger loan amount, causing a perpetual increase in loan costs in the absence of interest repayments.
If there is loan interest crediting, it is not paid back on the loan. Any loan interest credit is paid back into the investments in the cash value of the life insurance and does not reduce the loan or the loan interest.
Life insurance loans can provide a source of cash for policyholders at a lower interest rate than other loans when needed. However, it is important to consider the risks and benefits of taking out a life insurance loan.
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