Sometimes the unexpected happens and you need cash. Borrowing from your life insurance policy is one option.
Your cash-value whole, universal or variable universal life policy can appear a tempting source for a bailout, especially if you've been paying into it for years. After all, the quick-cash loan option was one of the features that sold you on permanent life insurance in the first place.
But before you borrow from your policy, consider the dangers ahead should you neglect to pay the interest on your loan -- or worse, trust that the dividends from your variable universal life insurance policy will automatically cover it.
"The biggest thing that people don't understand, including the agents selling it, is the intricate taxation that takes place inside a life insurance policy," says Al Barnes, a life insurance specialist in Alabama. "Borrowing from a cash value like that is sort of like building your house right on top of the San Andreas Fault -- only you don't know the San Andreas Fault exists."
Not your standard loan
On the surface, a policy loan appears simple: You can typically borrow up to the cash value you've accumulated in the account. If you have a variable universal life policy, the insurer will move the loan collateral (a cash sum equal to your loan amount) out of your investment fund and into a guaranteed or fixed fund.
"We don't want to expose that collateral to market downturn that could result in negative equity in the policy to where you basically lose your policy," says Paul Wetmore, assistant vice president for individual life products at MetLife.
Unlike a conventional loan, you don't have to pay a policy loan back; any money you take out will simply be deducted from your death benefit, which goes to your beneficiaries.
But that's where the good news ends.
Costs to consider
Exactly like a conventional loan, you'll be charged interest ranging anywhere from 5 percent to 9 percent on the loan, says Barnes. Unpaid interest will be added to your loan amount and will be subject to compounding. That's right -- you'll be paying interest on your interest.
"What people don't realize is that interest has to be paid. You're going to pay it either out of your pocket or you're going to borrow it (from your policy)," says Barnes. "It's exactly like borrowing on your home equity line. Just run an illustration of that and see what happens to your home equity."
If you have a variable universal life policy, you may also be charged an "opportunity cost," which is the difference between what your collateral was making in the investment account and what it will make in the guaranteed account. For example, if the invested portion of your account was earning 6 percent and the guaranteed fund earns a fixed 4.5 percent, you can add the difference, or 1.5 percent, to your interest rate to cover the earnings your insurer will forfeit by pulling that loan money out of the market.