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Life insurance policies are typically purchased to provide financial peace of mind to your family when you pass away. However, several types of life insurance policies have features beyond providing a death benefit. You may be able to borrow money from your insurance company using the cash value portion of your life policy as collateral. If you choose to take out a loan with your insurer, you may want to be sure that you understand how it works first. Bankrate examined some common situations where people borrow against their life insurance policy, but you’ll want to speak with a licensed insurance professional or a customer service representative at your insurance company to find out exactly how it works for your policy.
- You can borrow against a permanent life policy, but not a term policy.
- There is no hard credit check or collateral requirement when borrowing against life insurance.
- Interest accrues when borrowing from cash value, and any outstanding balance will likely reduce the death benefit.
Can you borrow from your life insurance policy?
You can typically take out loans against permanent life insurance policies, but not term life insurance policies. Life insurance loans use cash value accounts as collateral. Term life insurance policies do not come with a cash value account, so policyholders can’t borrow money from their insurer against these policies. This is one benefit of permanent life insurance vs. term life. A term policy has only one financial consideration: the beneficiary’s death benefit if the insured person dies during the policy term.
Permanent life insurance, such as whole life, is another story. With whole life insurance, a portion of your premium payment will go toward the death benefit, while another part will go into a cash value account that builds value over time.
If you are considering borrowing from your life insurance policy, keep in mind that it takes time to build cash value. You have to reach a certain threshold before you can take cash value out of the policy, which could mean you are unable to borrow against the policy when you need the money. This differs from a savings account, which allows you to remove money as needed, usually without reaching a certain threshold first.
In addition, if you fail to pay back interest on the loan, the amount you owe could be deducted from the death benefit. Policy lapses can jeopardize your financial protection if your family is still planning to rely on your life insurance policy.
When you should borrow from your life insurance policy
Borrowing money from a life insurance policy may be a better option than borrowing money from a bank for some policyholders. If you have poor credit or have been turned down for a bank loan, borrowing against your life policy may provide the funds your bank will not. It can also provide a way to pay off higher interest debt, as interest rates tend to be lower than other bank loans or credit cards.
Potential benefits include:
- There is no hard credit check. When taking out life insurance loans, there is typically no impact on the borrower’s credit rating. For those with poor credit, this may be the best way to secure a loan.
- Only your policy will be used as collateral: When someone’s home is used as collateral, and they default on the loan, they stand to lose their house. If the collateral is the policy, the worst that could happen would be that the life insurance policy would lapse, which could be a more attractive option.
- Your family may no longer need your death benefit. A widow in her 70s with grown and financially independent children may find a policy loan has more value than leaving money to her heirs.
Disadvantages of taking a loan out on life insurance
While there may be advantages to taking out life insurance loans, borrowing money from your life insurance policy also has some potential drawbacks.
You may want to consider these potential cons before taking out life insurance loans:
- You risk losing your life insurance policy and incurring tax penalties if the loan is not paid back on time with interest. If payments on the loan stop, the insurer will instead take the money directly from the policy’s death benefit, cash value or dividends, if those are included.
- Your policy’s cash value can’t be borrowed against until it has built up enough over time. The amount available to borrow for the first few years is negligible, and it usually takes a decade or so to build up enough reserves to make borrowing worthwhile.
- Other life insurance policy benefits may also lapse when a loan is taken. For example, for those who have an accelerated death benefit rider, which allows the insured person to use a portion of their death benefits for care if they become terminally ill, the amount borrowed may be deducted from the amount available for that purpose.
How to borrow from your life insurance policy
Taking a loan out on life insurance is fairly straightforward. The first step is to determine whether your life insurance policy is one of several types of permanent policies that are eligible for borrowing, including:
- Whole life (also called ordinary life)
- Universal or adjustable life
- Variable life
- Variable universal life
Unlike a bank loan, there is generally no approval process to secure a loan against a life insurance policy. It may also be possible to take the loan as a cash surrender value line of credit to be drawn from as needed.
Interest on the loan will begin to accrue immediately at a rate determined by the insurer, which may be lower than the rate a bank would charge for a similar loan. Loan repayment could begin immediately and is usually divided into monthly payments.