Life insurance is often thought of as a safety net for your loved ones after you pass away, but did you know that certain types of life insurance can provide financial benefits while you’re alive? Borrowing with a life insurance policy allows you to access funds when you need them, using the cash value that accumulates over time. It can be an attractive option in situations where you want to avoid taking out a traditional loan or depleting your savings.
At Bankrate, we help you analyze your life insurance policy in detail to give you the information you need to make informed financial decisions. This article explains how to borrow from life insurance, what you should consider before borrowing, and how it can affect your long-term goals. Whether you want to cover an emergency expense or fund a major life event, understanding how life insurance loans work can open up new financial possibilities.
Can I borrow from life insurance?
Yes, you can borrow against a life insurance policy, but only if there is a cash value component. Think of this as financing yourself with the value you’ve built over time. However, don’t expect to have immediate access to these funds. Most policies incur surrender charges for the first 10 to 15 years, which taper off over time. Insurance contract loans can only be borrowed from surrender value, not reserves. So unless you have something like lump sum insurance or limited payment insurance where you pay out a large amount at once and start building cash value quickly, that cash value may not grow long enough to allow you to borrow. will take several years. allows you to pay off your policy within a set number of years, allowing you to build cash value faster.
Here’s a breakdown of the most common types of insurance borrowed according to cash value:
However, it is important to remember that borrowing from an insurance policy is not without risk. If you do not repay the loan, it will be deducted from your death benefit. Worse, if the cash value drops so much that the loan remains unpaid, the policy may lapse, leaving you without coverage and potentially resulting in a phantom income tax. Therefore, borrowing with life insurance can be a financial savior, but it is important to tread carefully and know all the details in advance.
What is phantom income?
In the context of life insurance, ghost income is money for which a policyholder may be owed income taxes, even if they technically didn’t receive the money. For example, a policyholder wants to cancel the policy with a cash surrender value (CSV) of $100,000, but has a loan balance of $80,000. They pay $30,000 in insurance premiums. This is their cost base. Tax law states that you must pay income tax on withdrawals that exceed your cost basis. Therefore, the policyholder must include $70,000 in taxable income on their tax return. However, policy financing must also be considered in this scenario. The loan must be repaid before the insurance company pays the CSV check to the policyholder. In the end, the policyholder only receives $20,000, but still owes a total of $70,000 in taxes. Fictitious income is $50,000 that the policyholder did not actually receive.
Advantages of borrowing from life insurance
Borrowing with a life insurance policy comes with some pretty unique benefits. Not only do we give you access to funds when you need them, but we also offer flexibility that traditional loans can’t match. Here are some notable benefits that you might want to think twice about before heading to the bank.
- There are no complicated procedures and only cash is accepted. Forget about long applications and approvals. With life insurance loans, there are no credit checks or complicated processes. If your policy has sufficient cash value, just request a loan and you’re good to go. There are no stressful waiting times and you can access the money you need right away.
- Your loan, your rules: Need funds for an impromptu home repair or a dream vacation? You can spend your money however you like. And unlike traditional loans, you don’t have to justify your spending to anyone. It’s your policy and how you use your cash is completely up to you.
- Never seen or heard of: Unlike bank loans, life insurance loans are completely unknown. These loans are not reported to credit agencies or the government, so you don’t have to worry about your credit score being negatively affected. This is a completely private transaction between you and the insurance company.
- repayment? Only if you wish to: With a life insurance loan, there is no pressure to pay it back right away. In fact, you don’t have to pay it back forever. If you want, you can also pay interest only so the loan doesn’t eat up your cash value. If you choose not to repay your loan, the unpaid balance will simply be deducted from your death benefit before being paid to your beneficiary.
- No risk to your assets: Unlike traditional loans, where you have to put your home or car at risk, borrowing from a life insurance policy only affects the policy itself. In the worst case scenario, if you don’t repay the loan, your death benefit will be reduced and you may be charged taxes, so you don’t have to worry about losing your home or other assets.
These benefits give life insurance loans flexibility and ease not available with traditional financing options. If you need financial support without the hassle, it may be a smart choice.
Borrowing cash from an insurance policy is convenient and minimizes red tape, but it can potentially deprive your loved one of future financial security.
Disadvantages of taking out a loan with life insurance
Borrowing from a life insurance policy has its perks, but it’s not without some important caveats. Because not all that glitters is gold, here are some disadvantages to consider before you decide to take advantage of the cash value of your policy.
- Interest, Silent Drainer: As with any loan, interest accumulates over time. If left unchecked, interest can eventually deplete the policy’s cash value. And here’s the kicker. Once the cash value is exhausted, your policy will lapse, you may lose coverage, and you may be subject to large tax penalties.
- Goodbye, cash value growth: Borrowing with a life insurance policy can slow the rate at which cash value increases. Depending on the type of insurance you have, taking out a loan will usually reduce the amount transferred to your cash value or dividends, slowing down the steady accumulation you’ve built up. Growing a nest egg is like taking one step forward and two steps back.
- Reduction of death benefit: One of the most significant disadvantages of borrowing from insurance is that the death benefit is reduced if the loan is not repaid. The longer the loan lasts, the less the beneficiary receives. This means you may be borrowing your future financial security from a loved one.
- Rider reduction: If your policy includes special features such as an accelerated death benefit rider (allowing you to access funds early in the event of a terminal illness), the amount of these benefits available to you by borrowing from your policy may decrease. The more you borrow, the fewer benefits you will receive from other insurance policies.
So, while borrowing through a life insurance policy is a useful tool, it’s important to consider these potential drawbacks. Be careful not to trade short-term financial relief for the loss of long-term coverage.
How to borrow from life insurance
Taking out a loan from a life insurance policy is not complicated. In fact, it is one of the simplest financial methods. There’s no need to jump through hoops, apply for approval, or wait for a credit check. If your policy has accumulated enough cash value, the process is as simple as applying.
The loan structure is as follows.
Contact your agent or insurance company, fill out some basic forms, and if the cash value is sufficient, you’ll have your funds in your hands in just a few business days. No long wait times or stressful approval processes. It’s your money and it’s available when you need it.
As for the interest rate, it depends on the details of the policy. Some policies lock in fixed interest rates, while others adjust based on market indicators. Either way, interest starts accruing quickly, so it’s always important to keep that in mind, especially if you’re planning on taking your time to pay it off.
This process is very simple, but remember that just because cash is available doesn’t mean it’s free money. Borrowing from insurance can have long-term implications, so it’s worth weighing your options and thinking about your future before taking the plunge.
