Borrowing Against Cash Value Pros and Cons

Borrowing Against Cash Value Pros and Cons

Borrowing against cash value is simple because there are no loan requirements aside from the total cash value you have in your policy. You can use the life insurance policy loan for any purpose and pay back whenever you can. You can also take a life insurance policy loan to pay your premiums on the policy 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 types of 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’re unable to pay the loan your policy may lapse, and you will lose coverage, and you may also have a significant tax payment to make.

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

FOR EASIER NAVIGATION:

WHAT IS CASH VALUE LIFE INSURANCE?

CAN YOU BORROW AGAINST CASH VALUE?

HOW LIFE INSURANCE POLICY LOAN WORKS

HOW MUCH CAN YOU BORROW AGAINST CASH VALUE?

BORROWING AGAINST CASH VALUE PROS

BORROWING AGAINST CASH VALUE CONS

HOW DO YOU BORROW AGAINST CASH VALUE?

WHAT ARE THE ALTERNATIVES TO LIFE INSURANCE POLICY LOAN?

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 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. 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 term of the policy.

While the specific rate of interest differs between insurance companies, but it is typically around 6% per year. The cash value is equal to the money you would receive if you surrender 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 wouldn’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 life insurance personal 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 requires repayment according to the standard rate of interest 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 with a bank loan; the application for 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 the amount of your cash value, and the policy itself 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 end up with negative equity. If you do not pay the loan, when you die, the insurance company will deduct the outstanding balance from the policy’s death benefit amount.

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.

When you make a policy loan, you’re not actually withdrawing money from your cash value. 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.

You don’t have to pay your policy loan in a specific period unlike other types of loans since the cash value is being used as collateral. However, if you don’t pay the annual interest (which may be fixed or variable) on your loan, 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, while you can borrow almost the entire amount of the cash value, this can be unsafe.

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 having to pass a credit check or demonstrate proof of income to qualify. There are no questions 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. Your policy loan doesn’t show up on the credit report, unlike credit card debt.

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 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 W2’s, tax returns and other financial documents to find out if you will even 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 answer a simple form, 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 emergency purposes.

Low-interest rates

Making a policy loan is a much more affordable option 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 borrowing the cash value itself, your cash value continues to grow which offsets the interest on the insurance policy loan.

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 own schedule, fast or slow, steadily or in a lump sum.

When you borrow from the cash value, you don’t necessarily have to pay your loan. 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’re unable to 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. When you pay off the loan, the full death benefit of the policy will be restored.

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 your loan 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 either 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 passed 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 be paying a lot in premiums but end up no coverage because of the policy lapse. You will also need to pay taxes if your outstanding loan is higher than the cash value.

Cash value may not be available

It takes many years to build up significant cash value in a permanent life insurance policy. Typically you will need five to ten years before you can build up enough cash value. In the early years of paying for the policy, there may not be enough cash value available 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. The policy will lapse if that happens, and you’ll need to surrender it to the insurance company.

Possible tax consequences

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

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

NEGATIVE TAX IMPLICATION OF POLICY LOAN

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

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. If you never paid the principal and interest, the total loan balance would equal the full cash value. The policy will lapse when that happens, and the insurance company would 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 and 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 in comparison to your cash value and make regular payments on the loan, you can use the policy loan as a fast source or 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 ownership
  • The loan exceeds a certain amount, such as $50,000.

WHAT ARE THE ALTERNATIVES TO LIFE INSURANCE POLICY LOAN?

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

Home equity loan

The line of credit or home equity loan may be a possibility 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.

Both 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 need to pay the total amount due 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 together with 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 still apply. Before you pull money out of your retirement plant, you have to be aware of what it may cost you.

CONCLUSION

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

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