Christian F. Messina
April 11, 2019
If you’re low on cash and need funds to pay for college tuition, unexpected medical bills, mortgage payments or other expenses, one option is to borrow against the cash value of a permanent life insurance policy. Policy loans typically offer significant advantages over credit cards and personal bank loans, including lower interest rates, flexible repayment terms and a speedy approval process. But these loans aren’t risk-free. Consider both the potential advantages and disadvantages before you take out a policy loan.
Tapping cash value
Most insurance companies allow you to borrow amounts as high as 90% to 95% of a whole or universal life policy’s cash value. These loans offer several advantages over traditional loans, including:
Lower costs. Interest rates are usually lower than those available from banks and credit card companies and there are little or no fees or closing costs. In addition, although you’re not paying the interest to yourself (see below), your interest payments may benefit you indirectly if your insurer distributes a portion of its profits to policyholders as dividends.
Simplicity and speed. So long as your insurer offers loans, there’s no approval process, lengthy application, credit check or income verification. Generally, you can obtain the funds within five to 10 business days or less.
Flexibility. Most insurers don’t impose restrictions on how you use the funds. And you have the flexibility to design your own repayment schedule. You can even choose not to repay the loan. However, that can have negative consequences.
Credit scores unaffected. Policy loans won’t appear on your credit report.
Generally no tax impact. Except as discussed below, policy loans are tax-free. They’re not considered income, nor are they reported to the IRS in most cases. This is a big advantage over surrendering a policy in exchange for its cash value. Surrendering can trigger taxable gains to the extent the cash value exceeds your investment in the policy (generally, premiums paid less any dividends or withdrawals). Note that interest paid on the loan typically is not deductible.
Recognizing potential pitfalls
Before you borrow against a life insurance policy, be sure to consider the disadvantages, including:
Reduced benefits for heirs. If you die before repaying the loan or choose not to repay it, the loan balance plus any accrued interest will reduce the benefits payable to your heirs. This can be a hardship for family members if they’re counting on the insurance proceeds to replace your income or to pay estate taxes or other expenses.
Possible financial and tax consequences. Depending on your repayment schedule, there’s a risk that the loan balance plus accrued interest will grow beyond your policy’s cash value. This may cause your policy to lapse, which can trigger unfavorable tax consequences and deprive your family of the policy’s death benefit.
Eligibility. You can borrow against a life insurance policy only if you’ve built up sufficient cash value. This can take many years, so don’t count on a relatively new policy as a funding source.
Dispelling a myth
There’s a common misconception that, when you borrow against a life insurance policy, you’re “borrowing from yourself.” In other words, when you pay interest on the loan, you’re essentially paying yourself.
This may be true when you borrow money from a retirement plan (see “Retirement plan loans have hidden costs”), but it’s not accurate when it comes to life insurance policy loans. In fact, you’re borrowing from your insurer, pledging the cash value of your policy as collateral and paying interest to the company. Policy loans may be cheaper than traditional loans, but they’re not free.
Reviewing your options
A life insurance policy loan can be an attractive, cost-effective source of funds to meet current expenses. Before you borrow against a policy, be sure you understand the risks and evaluate the relative pros and cons of traditional loans. Make sure you really need to borrow and consider whether you have alternatives, such as selling an asset or reducing expenses.