Life insurance is an important tool that helps you protect your loved ones from financial distress if you die.
There are also advantages to life insurance beyond the death benefit. If you have a policy with a cash value component, you can borrow money from your life insurance. Cash value life insurance can be one of the most convenient, low-cost financing options out there. But there are also pitfalls to avoid if you go this route.
How Do You Pay Back a Life Insurance Loan?
Unlike most types of loans, life insurance policy loans don’t have a specified repayment period. You can take as long as you, please.
There can be negative consequences, however, for keeping the funds indefinitely because interest accumulates. That’s why if you borrow against your policy, it’s a good idea to pay the loan back in a timely manner.
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Policy loans can be repaid in one of three ways.
Cash
Ideally, you would repay your loan with cash payments to the life insurance company. “Repaying in cash increases both the policy account value and the death benefit by the amount of the repayment on a dollar-for-dollar basis,” Flagg says.
Policy value
Flagg says that if costs being charged in a policy can be reduced, and the cash value is then more than enough to cover reduced costs, a policy loan can be repaid with “excess” cash value. He warns, however, that if the amount of the loan repayment is greater than the amount of the policy cost/tax basis, then repaying this way can trigger a taxable event.
Death benefit
If your policy loan balance is still outstanding when you die, the loan balance will be deducted from the death benefit. Your beneficiaries will receive a reduced benefit. Even so, Flagg says that because death benefits are received tax-free, repaying policy loans this way is the most tax-efficient means of repayment (versus repaying with cash that has already been taxed or a withdrawal of excess cash value that could be taxed).
What Happens if You Can’t Pay Back a Life Insurance Loan?
If you don’t repay your policy loan or make payments toward the interest, the interest will compound and be added to the balance. If this goes on for long enough, the amount borrowed could exceed the policy’s cash value, which would cause the policy to lapse.
“Then the full amount of the loan becomes taxable as phantom income,” Flag says, which he explains is taxable income with no actual cash income to pay the tax. The loan balance is also taxed at ordinary income rates instead of more favorable capital gains tax rates.
If you die before repaying the loan balance, the insurance company will deduct it from your death benefit. So your beneficiaries will receive less and essentially repay the loan on your behalf.
Pros and Cons of Borrowing Money from Life Insurance
Before borrowing money from your life insurance policy, consider these pros and cons.
Pros
No credit check required: Since you are borrowing your own money, there is no formal credit check needed to qualify for a policy loan.
Low-interest rate: Policy loans are a low-interest financing option. Interest rates range between about 5% to 8%, depending on whether they are fixed or variable.
Pay it back when you want: There is no formal repayment timeline, so you can make payments toward the balance as it fits your budget and cash flow.
Cash value keeps growing: Your policy’s cash value simply serves as collateral, so the funds continue to sit in your policy and gain interest.
Cons
Minimum cash value required: You need to have sufficient cash value before you can take a loan. So if your policy is fairly new, it could take years to build up a decent cash value amount.
Borrowing amount limited: You can only borrow up to a certain percentage of your cash value. So if you need to borrow more, you may have to explore other (potentially more expensive) financing options.
Reduced death benefit: If you don’t pay your loan back before you die, it will be deducted from your beneficiary’s death benefit.
Risk of lapse: Even though you don’t have to pay your loan back according to a set schedule, interest will continue to accrue and the insurer will still make charges for policy expenses. If the balance of your loan grows past the policy’s cash value, the policy could lapse. This would mean you’d have to make an infusion of premium money to keep it in force.
Alternatives to Borrowing Money from a Life Insurance Policy
When done correctly, a life insurance policy loan can be a convenient, low-interest way to borrow money. However, if you want to avoid the risks associated with borrowing from your life insurance, consider these other ways to leverage the cash value.
Withdrawal of cash value
Instead of borrowing money from your life insurance, you can simply withdraw cash from it. As long as you withdraw only up to the amount you’ve paid in premiums so far, you won’t have to pay taxes on the funds. The downside is that a withdrawal will generally reduce your death benefit.
Surrender of policy
If you no longer need life insurance, one option is to surrender your life insurance policy for cash. This can be a good option if you no longer have dependent children or a large amount of debt and need cash for your retirement. Keep in mind that some policies charge surrender fees, reducing the amount you receive.
Get all the benefits of Life Insurance and protect your family without going over budget.
Get in touch and get a free personalized quote!
Source: https://www.forbes.com/advisor/life-insurance/borrowing-against-life-insurance/
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EPIA inc. is a private Insurance Agency with no ties with legal entities. The information contained in this article is based on information provided by the Medicare Official Website.
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