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- Permanent life insurance policies have a cash value in addition to a death benefit.
- You can take a loan against the cash value of your permanent life insurance policy.
- If you don't repay the loan, you risk decreasing the death benefit for your beneficiary.
Cash value is a unique feature of permanent life insurance policies that allows you to grow your policy. The cash value is yours to use within certain limits. For example, you can use it to increase your death benefit, withdraw from, or borrow from. Before taking a loan from your policy, it's important to be aware of its drawbacks.
Not all life insurance policies are alike
There are two main types of insurance policies:
- Term life insurance: This policy provides temporary coverage, usually between 10 to 30 years.
- Permanent life insurance: This policy offers lifelong coverage and accumulates cash value.
Cash value is a saving or investing component of your insurance policy that earns interest on a tax-deferred basis. Different types of permanent life insurance policies serve different purposes and grow cash value differently.
- Whole life insurance: Offers cash value growth at a fixed death benefit and premium premium with a guaranteed minimum interest rate.
- Universal life insurance: Offers cash value growth with an adjustable premium and death benefit at a guaranteed interest rate.
How does borrowing against life insurance work?
Mark Williams, CEO of Brokers International, says that when you take a policy loan, you're essentially borrowing from the insurance company, using your policy as collateral. A loan allows you to avoid withdrawals from your policy, which could be taxable.
Although policy loans are tax-free, you must pay it back with interest. The interest you pay is based on current market rates and can be fixed or variable depending on the type of permanent life insurance policy you have.
It's worth noting that not all insurance companies allow you to borrow from your policy. If you're interested, be sure to speak to a representative about your options. You'll also want to inquire about borrowing limits, as you typically can't borrow your entire cash value amount.
Why consider a life insurance loan?
Quick access to cash
Since life insurance loans don't require an approval process, obtaining one is typically faster and easier than traditional loans.
Flexible use of funds
You can use your life insurance loan for various financial goals or needs, such as paying your children's college tuition, funding a business, or purchasing a second home.
No credit check
Insurance companies perform a credit inquiry on your report since they don't use your credit score to evaluate loan eligibility. So your credit score isn't impacted. Unlike traditional loans, policy loans allow access to favorable terms like flexible repayment plans and low interest rates regardless of your score or income.
Potential drawbacks of a life insurance loan
Reduces Death Benefit
Williams said you can pay the loan back or never pay it back and keep the policy until you die. However, he noted if you die with an outstanding loan, the insurance company will reduce the death benefit payable to yourlife insurance beneficiaries by the outstanding loan amount.
Interest accrues
Life insurance companies charge interest on the loan balance. If the accumulated loan and interest exceed the cash value of the policy, you might need to pay additional premiums to keep the policy from lapsing or ending.
Policy could lapse
If you can't pay your policy back with interest, your policy could lapse. This could result in a taxable event if the unpaid loan balance exceeds the premiums paid into the policy.
Life insurance loan FAQs
Do I have to repay a life insurance loan?
Technically, you do not have to repay your insurance loan, but it greatly lessens what your loved ones receive if you pass away.
Are there tax implications to a life insurance loan?
Usually, there are no tax implications if you repay your loan. However, if you do not repay the loan and your policy lapses or surrender it, you may have to pay taxes on the loan amount and the accrued interest if they exceed the premiums you paid into the policy. Consult a financial advisor or tax professional to understand how specific tax rules affect your life insurance loan.
Is borrowing against my life insurance a good idea?
Borrowing against your life insurance can be a good idea depending on how an insurance loan compares to other loans you qualify for. Weigh their rates and how a loan would impact your life insurance policy.
Alani Asis is a personal finance expert covering insurance, retirement, credit cards and more. In addition to writing reviews, guides, and personal finance explainers for Business Insider, Alani was a Mortgage Support Specialist. You can reach her via Twitter at @AlaniAsis.
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