Taking out a loan as part of a permanent life insurance policy may seem tempting, but it also has drawbacks. While a loan allows the policyholder to access cash value, doing so will typically reduce the death benefit the beneficiary receives if the loan is not repaid in full. It’s important to weigh the pros and cons before applying for a life insurance loan, considering the implications for your inheritance. This decision is important because you may have a better chance of obtaining funds such as savings or other low-interest loans without jeopardizing your policy payout.
Pros and cons of life insurance loans
Before taking out a loan for life insurance, carefully weigh the pros and cons. While cash value loans have some advantages, such as lower interest rates on life insurance loans, they can also reduce the death benefit passed to beneficiaries if not repaid in full. This potentially major disadvantage means you should first look for alternatives, such as: B. Liquid savings or other low-interest personal loans that won’t jeopardize your inheritance. A financial planner can help you analyze whether a life insurance loan is right for your situation.
Pros and cons of life insurance loans
| Pros | Cons |
|---|---|
| Tax benefits: Cash value grows tax-deferred, and if you take a loan, it is tax-free, though interest will accrue. | Death benefit could be reduced: If you don’t pay the loan amount and interest back in full before death, the outstanding balance will typically reduce the death benefit amount your beneficiary will receive. |
| No set payment terms: Unlike a traditional loan, there are no set repayment terms. You can pay back the loan monthly, quarterly, annually or decide not to pay it back at all, though this would lower your death benefit when claimed by your beneficiaries. | Interest will accrue and can compound: The insurance company determines the life insurance loan interest rate, which can be anywhere from 5 to 9 percent. Unpaid interest can compound, causing the loan balance to grow if not paid down. |
| No credit check: There is no credit check or qualification process. Even if you have poor credit or no credit, you can still take a loan against your life insurance cash value. | The policy could lapse: If the loan grows beyond the cash value account balance, it could cause the policy to lapse. If the policy lapses, there will be no death benefit for your beneficiary when you pass away. |
How do life insurance loans work?
Cash value is a key component of a permanent life insurance policy that allows the policyholder to obtain funds through a loan. Part of the premium is used to build a cash value that accrues interest separate from the death benefit. After a certain period of time (usually 2-3 years), the insurance company allows the policyholder to borrow against that cash value, under certain conditions.
The loan amount available depends on how much cash value has accumulated. To ensure that the policy remains in effect, insurance companies typically only approve loans up to a certain percentage of the total cash value. The unpaid loan balance is usually deducted from the death benefit paid to the beneficiary. However, the cash value itself remains the property of the insurance company and is not distributed to beneficiaries upon death.
When weighing the pros and cons, it’s important to understand that policy loans are based on cash values and not death benefits. While the policyholder has access to funds, they may have a reduced estate if the loan is not repaid in full.
How do I take out a loan from my life insurance?
To get a loan from life insurance, you must first have the right type of policy. Permanent life insurance is the only type of life insurance you can borrow. Part of the policy is a cash value savings account. The insurance company takes a portion of each premium and credits it to a cash value account. Over time, the cash value grows, tax deferred, and accrues interest. How quickly it grows depends on the type of permanent life insurance you have:
- Life insurance provides a fixed monthly premium for the life of the policy and a guaranteed death benefit. Cash value automatically accumulates to guaranteed minimum interest rate.
- Universal life insurance provides additional flexibility because the monthly payment is divided into two parts: one part covers the life insurance and the other part is used for savings and investments to grow cash value.
- Variable life insurance combines a death benefit with a savings account that allows you to invest in stocks, bonds, and other investment vehicles of your choice. You can expand your policy faster, but you also bear the risks that come with being an investor.
Once you reach the cash value set by your insurance company, you may qualify for a mortgage. There is no credit check or application process when applying for a life insurance loan. To get a loan, you will need to apply for a loan amount from an insurance company, which will set up the loan and set the interest rate on the life insurance loan. As with bank loans, there are no fixed repayment terms.
Although you do not have to repay the loan, it is recommended that you do so.
Do life insurance loans have to be repaid?
Yes, life insurance loans generally require repayment, but there is some flexibility in repayment. The policyholder is typically required to repay the loan principal and interest over his or her lifetime. This means the beneficiary will still receive the full death benefit.
Failure to repay a life insurance loan and the total of the loan and interest exceeds the death benefit amount may cause the policy to lapse without any payment being made to the beneficiary. When the policyholder dies, the unpaid amount is typically deducted from the death benefit, technically “paying off” the loan by reducing the amount the beneficiary receives.
