Borrowing Against Cash Value Pros and Cons – 2022 Update

Borrowing against cash value is simply because there are no loan requirements aside from your total cash value in your policy. You can use the life insurance policy loan for any purpose and pay it back whenever you can. You can also take a life insurance policy loan to pay your premiums if you choose the automatic premium loan option when you purchase the policy.

Cash value is a feature unique to permanent life insurance such as whole life, universal and variable life. These policies allow you to build cash value in the policy as you pay your premiums. Permanent life insurance provides death and living benefits. The death benefit is for the beneficiary, and cash value accumulates as the policy ages.

Some policies allow you to withdraw cash value or borrow against it as a policy loan. Life insurance loans typically have low-interest rates for borrowers. As long as you pay back the loan, borrowing against cash value will not affect the death benefit your beneficiary will receive when you pass away.

However, if you cannot pay the loan, your policy may lapse, lose coverage, and have a significant tax payment.

Before taking a policy loan, you’ll want to consider borrowing against cash value pros and cons carefully.

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What Is Cash Value Life Insurance?

Permanent life insurance policies are also called cash value life insurance. Unlike term life insurance which only pays the death benefit during the policy term, permanent life insurance pays out the benefit no matter when you die.

Cash value insurance has higher premiums than term insurance because of the investment-style savings component. Part of the premium in cash value insurance goes into a separate account that builds cash value.

Cash value accrues interest and grows over time according to the rate of interest your policy pays and the amount you pay each month. The accumulated earnings grow on a tax-deferred basis.


The cash value grows depending on the type of policy. A whole life insurance policy works like a savings account that earns interest at a predetermined rate. With a universal policy, the cash value grows at the interest rate of a predetermined index chosen by the life insurance company. While variable life insurance, the cash value is invested in a series of in-house mutual fund-like sub-accounts.

Can I withdraw money from my life insurance?

When there’s enough cash value on the policy, you can use it to:

  • Buy more coverage to boost the death benefit
  • Pay for life insurance premiums
  • Withdraw cash. (If you don’t repay the loan, the death benefit is reduced.)
  • Borrow money from the life insurance company. (Using life insurance as collateral)
  • Supplement retirement savings
  • Surrender the policy and receive the accrued cash value.


Can You Borrow Against Cash Value?

Each time you make premium payments for a permanent policy such as whole life, universal, or variable that has a cash value, part of the premium is put towards the cash value. The cash value accumulates at an interest rate set by the policy’s term.

While the specific interest rate differs between insurance companies, it is typically around 6% per year. The cash value equals the money you would receive if you surrendered the policy to the company.

Term life insurance policy is cheaper than permanent policies because they don’t have a cash value component; that’s why you can’t borrow against them. If you decide to surrender a term life insurance policy, you won’t receive any money in return.

Using life insurance to pay off debt is possible if your permanent life insurance policy is accumulating cash value. You can borrow or take a personal life insurance loan against the cash value. The insurance carrier will use the cash value as collateral for your loan. Borrowing against cash value is only available once your life insurance cash value has reached a certain level, which may take about five to ten years of premium payments.

While the insurance carrier may limit the amount you can borrow up to a certain percentage, usually 90% of the policy’s cash value – most carriers will allow you to borrow the full amount. As with any other kind of loan, cash value loans require repayment according to the standard interest rate and the full amount you borrow.


How Life Insurance Policy Loan Works

Monthly premium payments in a permanent life insurance policy change over time. You pay more during the first 10 to 15 years – you are technically overpaying for the policy – and then, as the years go by, premium amounts start to decline. This method creates cash value and keeps the premium payments at the same price as you age.

If you want to cancel the policy during the early years, the insurance carrier protects itself by setting a surrender charge to cover policy-related costs such as sales commissions. The real cash value of the policy or the surrender value is the difference between the cash value and the total surrender charge.

There is a lengthy application process and a full credit check on a traditional bank loan. A life insurance policy loan works differently.

You don’t have to go through the rigid application process like a bank loan; the application for a policy loan is streamlined. You only have to complete an application form and file your policy loan to the insurance company. Normally, you can borrow up to your cash value, and the policy serves as your collateral.

Repayment terms for a life insurance policy loan are flexible. You can pay whenever you can. You can continue to take out new loans as long as you pay the premiums.

Just be mindful of the loan amount and the interest, or you will have negative equity. If you do not pay the loan, the insurance company will deduct the outstanding balance from the policy’s death benefit amount when you die.


How Much Can You Borrow Against Cash Value?

The amount you can borrow from the life insurance policy varies by the insurance carrier, but the maximum amount of loan you can get is typically at least 90% of your cash value. There is no minimum amount you can borrow.

You’re not withdrawing money from your cash value when you make a policy loan. Instead, you’re borrowing from the insurance company and using the cash value as collateral. The cash value remains within your life insurance policy and does not diminish. It is still accumulating interest at a different rate.

Unlike other types of loans, you don’t have to pay your policy loan in a specific period since the cash value is used as collateral. However, if you don’t pay your loan’s annual interest (which may be fixed or variable), the interest will be added to your outstanding loan amount.

If the policy loan lasts several years, the interest on the loan will compound. The policy will lapse if the total outstanding loan equals the policy’s cash value.

When your insurance lapses, your coverage will be gone, and you will have to pay income taxes if the outstanding loan is higher than your cash value. Therefore, this can be unsafe, while you can borrow almost the entire cash value.

If you get a policy loan, you must pay the interest whenever possible and carefully monitor the outstanding loan compared with the cash value to maintain your coverage.


Borrowing Against Cash Value Pros

These are the advantages of a life insurance policy loan:

No credit check

You can borrow against your cash value without passing a credit check or demonstrating proof of income to qualify. No questions are asked if you have enough cash value on your policy.

The application process is easy compared to bank loans. You simply answer a loan form, and you will receive the payment. It works to your advantage if you have a spotty credit history or you don’t have a stable job. Unlike credit card debt, your policy loan doesn’t appear on the credit report.

Being able to take money out of your life insurance is an advantage. It is especially helpful if you don’t have emergency funds or other investments you can withdraw money from. And if you have had the policy for a while, you can borrow a much larger amount than what a bank can lend.


Taking a life insurance policy loan is easy.

Getting a loan from a bank can be a daunting task, especially today. You typically need to send W2s, tax returns, and other financial documents to determine if you qualify for a loan. On the contrary, a life insurance policy loan is easy.

You don’t have to go to a bank to file a loan. All you need to do is answer a simple form and show proof of identity, and in a couple of days, the insurance company will issue the loan. Since there are no credit checks or qualifications, policy loans can be a great solution if you need money for emergencies.


Low-interest rates

Making a policy loan is more affordable than a personal loan or credit card. Life insurance policy loans typically have lower interest rates than personal loans or credit cards. While rates vary by the insurance company and policy type, they usually fall within the range of 4% to 8%.

That does not match a bank loan for the same amount. The average rate on a personal loan from a bank can be higher than 10.05%, while the average interest rate for a credit card can be higher than 12.86%

The difference in the interest rate is because you’re borrowing against a policy that likely has a 4-5% internal rate of return. And since you are borrowing against your policy and not the cash value itself, your cash value continues to grow, which offsets the insurance policy loan interest.


Flexible repayment schedule

Repaying a policy loan is easier. Unlike most traditional loans, a policy loan does not have a fixed timetable for repayment. You can repay the life insurance cash value loan on your schedule, fast or slow, steadily or in a lump sum.

You don’t necessarily have to pay your loan when you borrow from the cash value. You could pay for it with your cash value, liquidating that part of your asset, but paying the loan. You also don’t have to pay the annual interest if your total outstanding loan doesn’t exceed the cash value.

If you cannot pay the policy loan, the loan balance will be repaid with death or surrender benefits. However, the death benefit proceeds will be reduced on a death claim or when the policy is surrendered. The policy’s full death benefit will be restored when you repay the loan.


The policy loan is not a taxable event.

Typically the IRS will never know that you borrowed from your cash value.  They never track your loan from the insurance company because it is not considered an income in most situations. It’s like taking a second mortgage or line of credit for a rental property. Your loan does not affect your credit because banks and credit reporting agencies do not track it.


Borrowing Against Cash Value Cons

These are the disadvantages of borrowing against cash value:

Risk of reduced payout

Although the interest rates may be favorable, you still need to pay interest on your life insurance policy loans. If you don’t repay the loan during your lifetime, the death benefit payout will be reduced when you die. The total outstanding balance will be subtracted from the death benefit payout to your beneficiaries when you pass away.


Risk of losing coverage

If your outstanding loan plus interest exceeds your insurance policy cash value, the policy will lapse. That’s why it is to your benefit to pay back the policy loan on time because the interest compounds annually, and the insurance policy will lapse if the loan plus interest gets too large.

You could pay a lot in premiums but end up with no coverage because of the policy lapse. You will also need to pay taxes if your outstanding loan exceeds the cash value.


Cash value may not be available.

Building up significant cash value in a permanent life insurance policy takes many years. Typically you will need five to ten years to build up enough cash value. In the early years of paying for the policy, there may not be enough cash value to borrow against.


Compounding interest

Even though the interest rate on the policy loan may be low compared with the bank loan, the interest can compound reasonably quickly. If you’re just paying the premiums and not paying for your loan, the accrued interest could inflate the loan balance exceeding the cash value. If that happens, the policy will lapse, and you’ll need to surrender it to the insurance company.


Possible tax consequences

Outstanding loan balances may cause tax events if you borrow more than your cash value and choose to cancel or surrender your insurance policy later.

The amount you borrow from your life insurance policy is not considered income. But loans can become a taxable event if you’re forced to surrender your policy. If you’ve cashed in a significant equity value, you’ll owe thousands of dollars in taxes.


NEGATIVE TAX IMPLICATION OF POLICY LOAN

The interest will accumulate if you don’t make payments on a policy loan. If you don’t pay the interest, it will be added to your loan balance, increasing your loan amount.

If you don’t make a payment on the principal or interest, your loan balance will equal the policy’s cash value, and the policy will lapse. At that point, the insurance company will surrender your policy, or they will use the cash proceeds from the surrender to pay off the loan balance. Thus, you will not receive any surrender proceeds from the policy.

So what’s the tax implication? Let’s say you have an insurance policy with a cash value of $300,000. Over the years, you paid $190,000 in premiums. If you want to surrender your policy and get the cash value, you will get the $190,000 you paid in, tax-free. Your $110,000 gain would be taxed. That would result in a $33,000 tax (if you are in a 17% tax bracket). You would get $267,000 after paying the tax.

Let’s see what happens if you have a loan. Say you borrowed $200,000 and never made any payments. The interest would compound over the years. The total loan balance would equal the full cash value if you never paid the principal and interest. The policy will lapse, and the insurance company will surrender your policy and use the proceeds to pay off the loan.

From the tax perspective, you owe $33,000 in income tax, but you will not receive any surrender proceeds from the policy to pay off the tax. If you managed your policy loans and paid your loan, you can enjoy the benefits of the loan, avoid the risk of lapse, and pay income tax.

The insurance policy loan provision is a benefit of permanent or whole life insurance. As long as you monitor your loan balance compared to your cash value and make regular payments on the loan, you can use the policy loan as a fast source of cash without the risk of unwanted tax liability.


How Do You Borrow Against Cash Value?

The process of borrowing against cash value is incredibly simple.

You inform the insurance company of your intention to borrow. They will give you an application form you need to fill out. You will have to confirm your identity by showing personal documents. Typically the money will be deposited in your account within a few days.

You may need to sign a confirmation document or provide a notarized confirmation if:

  • You provided new bank account information to the insurance company in the last month.
  • There’s a change in the policy owner.
  • The loan exceeds a certain amount, such as $50,000.


What Are The Alternatives To A Life Insurance Policy Loan?

If you’re not comfortable taking a life insurance policy loan, other options for getting a short-term loan are available.

Home equity loan

A line of credit or home equity loan may be possible for homeowners. These loans have favorable interest rates. The tax-deductible Home Equity Line of Credit has an interest rate as low as 3%. The lender will check your credit history and income before approving your application.

The borrower and the property must pass lending requirements, such as sufficient equity and a steady job with good credit standing. There are generally fees and interest involved in borrowing money against the property. Many lenders also charge substantial prepayment fees for short-term borrowers.


Retirement Savings Plan – 401(K)

You might also borrow from your 401(K) or take an early withdrawal from your IRA. If you borrow from your 401(K), your payments will be automatically deducted from your paycheck, and you need to pay interest on the amount you borrow. If you leave your job before the loan is paid, you must pay the total due amount to avoid a tax penalty.

Borrowing money from the retirement account can generate fees and taxes, and due to employer plan restrictions, some people find themselves unable to borrow from their 401(K) even in emergencies. When they are allowed to borrow, the amount is typically limited to $50,000 or 50% of the vested funds. And unless your reason is a down payment for a house, the loan must be strictly paid back within five years.

Taking money out of an IRA has some potential tax consequences. IRA withdrawal is subject to income tax and a 10% penalty if you take the money out before 59.5 years old. Qualified distributions from IRA are tax-free, but be mindful that the early withdrawal penalty may apply. Before you pull money out of your retirement plan, you must know what it may cost you.


Conclusion

Always take the time to talk with your life insurance agent to understand the ramification of borrowing against life insurance. Never assume that because you have a permanent life insurance policy, you should borrow against it.

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Additional Questions & Answers

What type of life insurance has a cash value?

Whole life insurance is the #1 type of plan with a cash value, and the cash value within the policy will grow over time.


What is the purpose of the cash value in life insurance?

The cash value in life insurance is there as a financial safety net. It can be used in an emergency, to help pay for college, or supplement retirement income.


What is the difference between cash value and death benefit?

The death benefit is the amount of money paid to the beneficiary upon the policyholder’s death. The cash value is the policyholder’s money that can borrow against or withdraw from the policy.


Can I take the cash value of my life insurance?

Yes, you can take the cash value of your life insurance policy. However, there are pros and cons to doing so.


What are the pros of borrowing against cash value?

The pros of borrowing against cash value include having access to money when needed, not worrying about repayment, and potentially earning a higher rate of return on the money borrowed.


What are the cons of borrowing against cash value?

The cons of borrowing against cash value include paying interest on the loan, reducing the death benefit, and potentially causing the policy to terminate if the loan is not repaid.


Should I borrow against my life insurance cash value?

Whether or not you should borrow against your life insurance cash value depends on your situation. You’ll need to weigh the pros and cons to decide if it’s right for you.


Do all insurance policies have a cash value?

No, not all insurance policies have a cash value. Term life insurance policies, for example, do not have a cash value component.


What is the difference between borrowing against cash value and withdrawal?

The difference between borrowing against cash value and withdrawal is that when you borrow against your cash value, you still have the life insurance policy and the death benefit. When you withdraw, you take the money out of the policy, and the death benefit is reduced by the amount withdrawn.


What are some other options for accessing cash value?

Some other options for accessing cash value include loans, withdrawals, and policy surrenders. You’ll need to weigh the pros and cons of each option to decide which is right for you.


How long does it take for whole life insurance to build cash value?

It takes time for whole life insurance to build cash value. The cash value grows slowly at first and then faster as the policy matures.


What does it mean to borrow against cash value?

Borrowing against cash value means taking out a loan against the cash value of your life insurance policy. The interest rate on a loan is typically lower than the interest rate on a traditional loan.


What are the risks of borrowing against cash value?

The risks of borrowing against cash value include paying interest on the loan and reducing your policy’s death benefit.


Is it smart to borrow against your life insurance?

Whether or not it’s smart to borrow against your life insurance depends on your situation. You’ll need to weigh the pros and cons of deciding if it’s right for you.


How do you calculate the cash value of insurance?

To calculate insurance’s cash value, you’ll need to know the death benefit, the premium, and the cash surrender value. You can use a life insurance calculator to help you with the calculation.


What happens to the cash value after the policy is fully paid up?

After the policy is fully paid up, the cash value remains in the policy. The cash value can be used to help pay premiums or be withdrawn or borrowed against.


What is the difference between cash value and account value?

The difference between cash value and the account value is that cash value is the policyholder’s money that can be borrowed against or withdrawn from the policy. The account value is the death benefit minus any loans and withdrawals.


What is the difference between the cash surrender value and cash value?

The difference between the cash surrender value and cash value is that cash surrender value is the amount of money you would get if you surrendered your policy. Cash value is the policyholder’s money that can be borrowed against or withdrawn from the policy.


What happens when a policy is surrendered for its cash value?

When a policy is surrendered for its cash value, the policy is canceled, and the policyholder receives a check for the cash value. The death benefit is not paid out.


How long does it take for whole life insurance to build cash value?

It takes time for whole life insurance to build cash value. The cash value grows slowly at first and then faster as the policy matures.


What are some other options for accessing cash value?

Some other options for accessing cash value include loans, withdrawals, and policy surrenders.


How soon can I borrow against my whole life insurance?

You can usually borrow against your whole life insurance policy after the policy has been in force for a certain period, typically two to five years.


What is the difference between a loan and a withdrawal from my cash value?

A loan against your cash value is like a personal loan from an insurance company. You borrowed money that you will need to pay back with interest. A withdrawal from your cash value is like taking money out of a savings account. The money withdrawn is not required to be paid back, but it will reduce the death benefit.


Do you have to pay back cash value life insurance?

Yes, you should pay back any loans you take out against your cash value with interest. Withdrawals from your cash value are not required to be paid back, but they will reduce the death benefit.


What is the difference between a traditional loan and a loan against cash value?

The interest rate on a loan against cash value is typically lower than the interest rate on a traditional loan.


What are the risks of borrowing against cash value?

The risks of borrowing against cash value include paying interest on the loan and reducing the death benefit.


What happens when cash value exceeds death benefit?

When the cash value of a life insurance policy exceeds the death benefit, the policy is said to be “overfunded.” This can happen if the policyholder pays more in premiums than is needed to keep the policy in force. An overfunded policy can be surrendered for its cash value or used as collateral for a loan.


How much can I borrow from my life insurance policy?

The amount you can borrow from your life insurance policy depends on the cash value of the policy, the loan interest rate, and the loan terms.


Who gets the cash value in a life insurance policy?

The cash value in a life insurance policy goes to the policyholder. The death benefit is paid to the beneficiaries.


How do I cash my life insurance surrender?

To cash in your life insurance policy, you must contact your insurance company and request a surrender form. Once the form is completed, you will receive a check for the policy’s cash value.


What is the difference between cashing out a life insurance policy and surrendering it?

Cashing out a life insurance policy means receiving a check for the policy’s cash value. Surrendering a life insurance policy means the policy is canceled, and the policyholder receives a check for the cash value. The death benefit is not paid out.


What is the difference between cash value and surrender value of life insurance?

The cash value is the amount of money in the policy that can be surrendered for a cash payout. The surrender value is the amount of money paid if the policy is surrendered. The surrender value is usually less than the cash value because it includes any applicable surrender charges.


What limits the amount that a policy owner may borrow from a whole life insurance policy?

The amount that a policy owner may borrow from a whole life insurance policy is limited by the cash value of the policy, the loan interest rate, and the loan terms.


How do I avoid tax on life insurance cash value?

To avoid paying taxes on the cash value of your life insurance policy, you can make withdrawals that are classified as “non-taxable.” Withdrawals that are considered “non-taxable” include funds used to pay the premiums, funds used for long-term care expenses, and funds used for certain medical expenses.


What happens if you don’t pay back a life insurance loan?

If you don’t pay back a life insurance loan, the policy will lapse, and the loan amount will reduce the death benefit. If the policy is surrendered, the policyholder will owe the outstanding loan balance taxes.


What happens when the cash value of a life insurance policy equals the face value?

When the cash value of a life insurance policy equals the face value, the policy is said to be “fully funded.” This means that the policyholder has paid enough in premiums to cover the death benefit. The policy will remain in force as long as the premiums are paid.


What happens if you don’t pay back a life insurance loan?

If you don’t pay back a life insurance loan, the policy will lapse, and the loan amount will reduce the death benefit. If the policy is surrendered, the policyholder will owe the outstanding loan balance plus taxes.


Is money borrowed from cash value taxable?

No, money borrowed from the cash value of a life insurance policy is not taxable.


Can I use my cash value to pay premiums?

Yes, you can use the cash value of your life insurance policy to pay premiums. This is called a “premium loan.”

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