Should you borrow against your life insurance policy?
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Do you need cash to help pay for your child’s college tuition, a home renovation, or maybe even a surprise tax bill in April? If you have a permanent life insurance policy with significant cash value, borrowing against the policy is a viable option.
What You Need to Know
As with all lending options, there are pros and cons, including differing qualification and repayment requirements.
You can only borrow against permanent policies that build cash value. Term life policies are not an option. (Permanent policies include variable life, variable universal life, whole life, and adjustable life.) To make the loan amount reasonable, you must have accumulated a sizable cash value, which can take time (~10+ years).
In addition, if the insurance policy is still needed to provide for your heirs, ensure you have the resources to pay off the debt promptly.
Advantages and Disadvantages
Advantages include:
- Quick access to cash with no preapproval or hard credit check (policy is the collateral for the loan).
- Poor credit does not count against you.
- Borrowed funds are not subject to federal or state income taxes.
- Repayment can be easy and flexible, and typically, there is no requirement to pay off the debt.
- Interest rates tend to be lower than those banks offer (think home equity line of credit and credit cards).
Disadvantages:
- If you pass away with outstanding debt on the policy, the balance will be paid from the death benefit, which reduces the amount passing to beneficiaries.
- If the loan balance becomes too high, exceeding the cash value, the policy will lapse, and the insurance company may terminate coverage. In this case, taxes would be owed on any gain in the cash value, not taking into consideration the loan balance (i.e., the cash value, less premiums paid).
Borrowing Terms
You can borrow up to 90-100% of the policy’s cash value, and interest rates for policy loans range between 5 and 8% today. Once you withdraw funds from the policy, interest begins accruing immediately.
As mentioned previously, repayment is flexible or even not required. If payments are not made, however, the outstanding loan balance will increase. If the policy death benefit is an integral part of your financial plan, it’s important to pay the interest expense at a minimum to avoid a lapse in coverage. Loan repayment out of pocket provides a more impactful debt reduction strategy than cash-value funds.
What to Do
To secure a loan against your policy, you must complete a form with your insurer and provide proof of your identity. Once completed, cash will typically be available to you within a few days.
Summary
It doesn’t make sense to purchase life insurance with the intent to borrow against it. However, suppose you have a permanent policy with a sizable cash value. In that case, you may consider using it as a resource for obtaining cash easily when other borrowing options are not available or appealing.
If the need for the policy death benefit is still part of your financial plan, make sure you have a strategic plan for repaying the full amount of the loan before it’s too late. As always, it’s best to consult your financial advisor to discuss all borrowing options before taking action.
Kathy Hower, CFP, is a Senior Wealth Advisor with Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. For more information, visit their website at www.bedelfinancial.com or email Kathy at khower@bedelfinancial.com.