Life insurance policies can help serve as a financial safety net, providing your loved ones with financial support in the event of your passing. But did you know that life insurance can also be a valuable source of funds during your lifetime? In this guide, we'll explore the concept of borrowing from life insurance policies, shedding light on key aspects to be aware of in order to make informed decisions.
Borrowing from a life insurance policy involves accessing the funds that have accumulated over time within the policy. These funds are often called the "cash value" of a policy. While the primary purpose of life insurance is to provide a death benefit to specified beneficiaries, certain policies allow the policyholder to tap into this cash value while they are still alive.
The Concept of Cash Value in Life Insurance
The cash value of a life insurance policy is the amount of money that has accumulated within the policy over time. This cash value can be considered a savings component and may be invested by the insurance company. Policyholders may be able to borrow against the cash value of some life insurance policy types, effectively using their policy as collateral for the loan.
Eligibility for Borrowing from Life Insurance
First, it is essential to understand which policy types may accumulate cash value. The question becomes whether a policy is a permanent life insurance type that provides coverage for the entire lifetime of the insured or if the life insurance policy is a temporary type that provides coverage for a specific term, such as 10 or 20 years.
Permanent vs. Term Life Insurance
1. Whole Life Insurance Policies
Whole life insurance policies are a type of permanent life insurance that builds cash value over time. Borrowing against a whole life policy is typically straightforward, as it accumulates cash value consistently throughout the life of the policy.
2. Universal Life Insurance Policies
Universal life insurance policies are another type of permanent life insurance and generally offer more flexibility in premium payments and death benefits. They also build cash value, which policyholders may be able to access through loans. However, cash value growth in universal life policies may vary based on factors such as interest rates and market performance.
3. Term Life Insurance Policies
A term life insurance policy is not a permanent type of life insurance because it only provides coverage for a specific term of the insured's life. Term life insurance policies do not build cash value. The premiums paid for term life insurance go towards the cost of providing life insurance coverage for that term and do not accumulate as cash value.However, some term policies offer the option to convert to permanent life insurance, such as whole or universal life. Once converted, the policy may accrue cash value that can be borrowed against.
Understanding Policy Values
Next, knowing more about the different kinds of value associated with life insurance policies is important.
Face Value, Death Benefit, and Cash Value
Life insurance policies can refer to the policy's value in different ways, such as:
- Face Value: The amount the designated beneficiaries will receive upon the insured's death.
- Death Benefit: Synonymous with the face value, this represents the payout to beneficiaries.
- Cash Value: The cash value is the amount of money available for borrowing or withdrawal. It grows over time as premiums are paid and may be influenced by the performance of the investments made by the insurance company, depending on the policy type.
Some policyholders believe that borrowing against the cash value will reduce the death benefit. However, borrowing against the cash value typically does not impact the death benefit, provided the loan is repaid. On the other hand, outstanding loans at the time of the insured's passing will be deducted from the death benefit paid to the beneficiaries.
The growth rates of cash value can vary significantly based on the type of policy and the insurer's investment performance. It is essential to review the policy's annual statements to track the growth of the cash value and evaluate whether it meets financial goals.
How Life Insurance Loans Work
It is important to understand how life insurance loans work before planning to take out such a loan. Here are some tips:
Process and Ease of Obtaining a Loan
Obtaining a loan from a life insurance policy doesn’t have to be a complicated process. The loan can be requested through the insurer and is typically secured by the cash value of the policy. Typically, no hard credit check is required, potentially making it an accessible source of funds.
Tax Implications and IRS Recognition
Life insurance policy loans are generally not considered taxable income by the IRS. This means income tax will not be owed on the borrowed funds. However, it's crucial to understand that if the loan is not repaid and the policy lapses or terminates, the outstanding loan balance may be subject to taxation.
Impact of Policy Loans on Cash Value and Death Benefit
When money is borrowed from a life insurance policy, the loan amount is deducted from the cash value. The cash value can continue to grow, but at a reduced rate, as it may take time to recoup the borrowed amount. Additionally, any unpaid loans and accumulated interest will be deducted from the death benefit upon the insured’s passing.
Repaying a Life Insurance Loan
Repaying a life insurance loan is a common concern. Consider the following:
Importance of Timely Repayment
Timely repayment of the loan is essential to maintain the financial integrity of a life insurance policy. Failing to repay the loan and interest can lead to undesirable consequences, such as policy lapse or reduced death benefit.
The Compounding Nature of Loan Interest
Interest on life insurance policy loans is typically lower than that of traditional loans. However, it's important to note that the interest compounds over time. As such, the longer it takes to repay the loan, the more interest will accrue.
Consequences of Loan Default
If the outstanding loan balance, including accrued interest, exceeds the cash value of the policy, the policy may lapse. In such cases, the insured could lose coverage, and the policy's financial benefits would no longer be available to them or their beneficiaries.
Effect of Unpaid Loans on Death Benefits
In the event of the insured's passing with an outstanding loan balance, the unpaid loans and accrued interest will be deducted from the death benefit paid to their beneficiaries. Depending on the amount of the loan and accrued interest, this can significantly reduce the benefit amount paid by the policy to their loved ones.
Potential Pitfalls of Borrowing from Life Insurance
Reduction in Death Benefit
Borrowing from a life insurance policy can reduce the death benefit paid to the beneficiaries if the loan is not repaid before the insured passes.
Risk to Policy Guarantees
Some life insurance policies have specific guarantees, such as a guaranteed minimum death benefit or cash value growth rate. Borrowing against the policy can jeopardize these guarantees, potentially altering the policy's original terms.
Additional Premium Costs
If a policy lapses due to unpaid loans or other reasons, reinstating the policy may come with additional premium costs. These costs can be higher than previous premium payments.
Borrowing Limits and Timelines
The amount that can be borrowed from a life insurance policy is typically determined by the cash value accumulated within the policy. Insurers often have established guidelines regarding borrowing limits, which may be a percentage of the cash value.
A policy loan can generally be requested at any time once the policy has accumulated sufficient cash value. While there is typically no strict timeline for borrowing, it's essential to consider financial needs and goals when deciding when to access a policy's cash value.
Specifics of Borrowing Against Different Policies
Whole life insurance policies are generally a good choice for borrowing against due to their consistent cash value growth. These policies can typically offer a stable source of funds and can serve as a financial safety net.
Universal life insurance policies may offer flexibility in premium payments and death benefits. Borrowing against these policies can be advantageous, but the growth of cash value may be subject to market fluctuations.
The Bottom Line
Borrowing from a life insurance policy can be a useful source of monetary funds. It can come with several advantages, including accessibility, and such loans typically do not require hard credit checks.
While life insurance policy loans can be a valuable financial tool, they come with responsibilities. It's essential to consider how a loan might impact the ultimate payable benefit and a plan to repay the loan should be developed. Insurance advisors or agents can be consulted for personalized guidance on borrowing from a life insurance policy.
If you have questions about borrowing from your life insurance policy or need assistance with your life insurance needs, Acrisure is here to help. Our life insurance policy experts can work closely with you, taking into account your unique needs and financial objectives. As independent life insurance brokers, we offer advice and can provide access to different insurance policy options from a variety of insurance companies. Contact us today or request a life insurance quote online now.