Have you ever been in a financial pinch where you needed cash quickly due to an emergency? Most of us have experienced an unexpected situation whether it was with your car, home or some other predicament. If you have a life insurance policy that grows cash value, then a life insurance policy loan may seem like a no brainer. To get the cash out of your policy, you can opt for either a policy loan or a cash withdrawal.
It may be a tempting to withdraw money if you have a permanent life insurance policy that has built up cash value- such as whole life, universal life or index universal life insurance. There is no doubt that it was one of the features that was sold to you when you bought your permanent policy.
However, before you move forward with a life insurance policy loan- you need to know the risks that lie ahead. Life insurance policy loans are some of the most misunderstood and complex features of a life insurance policy. If you aren’t careful, you can put your policy at risk and could leave you without coverage. You could also be putting yourself at risk for an enormous tax penalty.
What is a life insurance policy loan?
A life insurance policy loan is when a life insurance carrier issues a loan from the cash value of your policy as collateral. If you do not pay back your policy loan, the insurer will withdraw the loan amount from your death benefit.
How do loans on life insurance policies work?
The first thing we need to cover is how a life insurance policy loan works. When you want to borrow from the cash value of your life insurance policy- you need to have cash available. That seems obvious enough, but you’ll need to check in on how much cash you have on your policy’s statement. Just know that if your policy is relatively new (up to 10 years), you’ll typically have little to no cash value in your policy.
How do I take out a life insurance policy loan?
If you decide to move forward with a policy loan, your agent or the carrier’s customer service rep can help you. You will have to complete a form from your insurer and you may have to have your identity confirmed. They will process the loan request and you’ll receive the loan the same way you pay your premiums. For example, by check or direct deposit. The money should be sent to you or your account within several days.
Before any of this occurs, you need to strategize how you will pay back you policy loan. If not, you’re putting your policy at risk of reducing the death benefit, tax penalties or losing coverage.
Policy Loans vs Policy Withdrawals?
As previously stated, life insurance policy loans can be risky if you are not careful and purposeful with paying back the loan. Your life insurance policy loan is not a real loan in the classic sense. This is because the life insurance policy owner has not agreed to repay the cash that has been transferred from the insurer even though interest is charged. It really is an “advance” of money that the carrier will have to pay out from the terms of the life insurance policy. If you were to die before this loan (or advance) has been paid back, the death benefit will be reduced based on your unpaid balance.
With a life insurance policy withdrawal, you’re more or less reducing your policy’s death benefit and cash value. It is viewed as a partial surrender of the cash value net. It’s very important to know that if you withdraw funds that goes beyond the amount of premiums paid could be taxed.
When does the policy loan need to be paid back?
You can pay back your life insurance policy loan anytime you want. In fact, you don’t even have to pay it back. Also, the annual interest doesn’t have to be paid just as long as your outstanding policy loan total will not go beyond the cash value in your policy.
With that said, there is significant risk (potentially) if you don’t pay your loan back. If you don’t pay it back on time as your interest compounds every year- your policy may lapse if your loan becomes too big. This may also cause tax issues if your loan is larger than what you paid in life insurance premiums.
Warning: Unpaid Interest May Cause Problems!
Are you planning to pay your policy loan interest in a timely manner out of your pocket? If so, really you don’t have anything to worry about. However, if you have the life insurance company pay your policy loan interest with its cash value or dividends– you need to be warned. The reason to be concerned is if you have unpaid interest- it will accrue as income. This accrual will be added to your policy’s loan balance. When you owe more than the amount you borrowed you will need to pay back the entire loan. Have your insurer or agent run an in-force illustration to show you how a policy loan may affect your life insurance policy.
Life Insurance Policy Loan Pros and Cons
It’s very easy to borrow against your policy’s cash value because there aren’t any loan qualifications or requirements. However there are some advantages and disadvantages with a life insurance policy loan.
- Get cash quickly with very few restrictions.
- Great option if you can’t get a traditional loan.
- You don’t have to pay back your loan.
- Typically lower interest rates vs credit cards or personal loans.
- If you can no longer pay your life insurance premiums a loan may keep your policy just as long as your death benefit is larger than the amount of the policy loan.
- Possible Tax consequences if you owe money that you haven’t paid back.
- If you don’t pay back your loan, the interest can cut into your death benefit.
- Although low, you will be charged interest that will typically range somewhere between 5-9% on your loan.
- In some situations, your policy may not pay out a death benefit if you don’t pay back your policy loan.
Policy Loan Bottom Line
With permanent life insurance, policy loans are a great resource to access cash quickly and easily. It is not advisable for everyone and you need to be aware of the pros and cons of taking policy loans.
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