Guide to life insurance loans

Why do many people choose permanent life insurance over term life insurance when term coverage is much more cost-effective and typically has a more straightforward application process? First, term only remains in force for a specified period of time – usually 10, 20, or 30 years – while permanent policies stay in force until you pass away (assuming you don't terminate the policy and you continue to pay your premiums).¹

Second, permanent life insurance policies – whole life insurance or universal life insurance – have a “cash value” component which helps you build wealth on a tax-deferred basis.² After you’ve built up your policy, you can access the cash value for any purpose – from helping to pay college tuition, covering emergency medical expenses, funding home repairs, or supplementing retirement income.³ This article will help you understand more about:

• Policy loans and other ways to access cash value

• The difference between life insurance loans and withdrawals

• How loans may affect your life policy and death benefit

• When to borrow money via a policy loan

How to get a life insurance loan

Policy loans, which allow policyholders to borrow money against the cash value component of their life insurance policy, are often the preferred way to access cash value, for a number of reasons which we will explain below. However, before we do so, you should know that there are typically three other ways to make use of the cash value of a permanent life policy:

• Surrender: One option is to cancel your policy and take the surrender value cash payment. However, with this option, you will no longer have life insurance coverage and the cash you receive will be reduced by surrender fees, which can be significant. Therefore, many experienced professionals feel that surrender before retirement should be a last resort, especially if you don't have other coverage.

• Withdrawal: In many situations, you can take a withdrawal. While that money may not be subject to income taxes, there are potential disadvantages: your death benefit will probably be reduced, and that reduction may be greater than the amount withdrawn, depending on your policy. Talk to your insurance professional or the insurance company to find out about their specific withdrawal rules and policies.

• Use cash value to pay your premiums: You can typically use the money in your cash value to pay part or all your life insurance premiums, allowing you to keep your coverage in force even if you're low on cash from other sources. This is typically a popular option for older policyholders who must use retirement income for living expenses but still want to keep their coverage.

• Life insurance loans: The fourth way to access cash value is by taking out a loan. Many insurers allow you to borrow up to 90% of your total cash value.⁴ The loan interest rate is usually lower than the rate on a personal or home equity loan, and the loan can be used for any purpose. But it’s important to note that many policy owners reserve this option for situations when they need “cash” that they intend to pay back. Why? Because if the loan is not repaid, you will end up with a reduced death benefit – the death benefit of the policy will be reduced by the loan balance and any interest accrued. There are also circumstances under which – absent repayment of the loan – the policy can lapse. So, these loans have both advantages and drawbacks, as do the other options mentioned above.

Life Insurance Loans: Advantages

• No impact on your credit: A policy loan doesn't require a credit check or any type of employment or income verification. Assuming that you have reached the required level of cash value, there is no approval process. Instead, you fill out a loan request, and generally, you will have the funds in a matter of days.

• A cost-effective affordable source of funds: The interest rate on policy loans is usually less than the rate charged for personal or even home equity loans.

• Cash value continues to compound: The funds for a life insurance policy loan don't come out of your policy. Instead, it's an actual loan, based on the policy’s cash value, from the life insurance company that issues the policy or a related entity. This means that your cash value will continue to grow (via interest or investment gains) even while you have an outstanding loan.

• You can choose to repay however you want – or not at all: You can repay the loan on whatever repayment schedule works best for you. Some policyholders choose to repay in one lump sum; others prefer to repay over time, in small, regular payments. Others may choose not to repay the loan at all – but any outstanding loan balance will be deducted from the eventual death benefit.

• You continue to have life insurance protection: If the loan balance plus interest is paid back in full and in a timely manner, the policy is unchanged, and the death benefit remains exactly the same as it was prior to taking out the loan.

Life Insurance Loans: Potential Drawbacks

• Loans may not be immediately available: It may take several years for your cash value to grow to a meaningful amount for you to borrow money against your policy. However, if your cash value has not reached that level, you'll have to look elsewhere for your loan.

• Unpaid loan balances reduce the death benefit: If you pass away before your loan balance is repaid in full, the benefit payout will be reduced by the amount still owed. In other words, your beneficiaries will receive less money.

• Coverage may lapse in certain situations: If you don't repay the loan promptly, there is a chance that the loan balance plus loan interest will exceed the cash value of your life insurance policy. If that happens, the insurance company can surrender the policy, leaving you without any life insurance coverage.

• There may be tax consequences: If you don't repay your loan balance and/or your policy lapses, you or your beneficiaries may owe income taxes on the amount borrowed. There are other potential tax consequences related to life insurance loans, so be sure to discuss them with your financial and tax professionals, insurance professional, or insurance company representative before taking out a loan.

Next Steps

Life insurance loans can be a convenient and cost-effective way for policyholders to access extra cash if the need arises. And, if one repays a policy loan in full and in a timely manner, there may be no financial drawbacks. However, before taking a loan against your life insurance policy, be sure to speak to a trusted financial and tax professional, your insurance professional, or an insurance company representative. They can help you to evaluate your options – withdrawal, surrender, or loan – and help you to better understand the pros and cons of each. If you do take out a policy loan, remember to keep a close eye on your outstanding loan balance: You want to make sure it is not approaching your cash value, which could cause the policy to lapse. However, if you make adequate loan payments in a timely manner, that shouldn’t be an issue.

Or, maybe you don't currently have a permanent life insurance policy, and you're interested in learning more about it can provide life-long protection while helping to build wealth with tax efficiencies. In that case, you should consider speaking with an experienced professional who can thoroughly explain how whole life and universal life insurance work and help you decide if either type of policy is a good fit for your financial needs. If you don't have a financial professional to discuss insurance with, Guardian can help you to find a nearby financial professional who will listen to your needs and help guide you to the right solution for you.