Are life insurance loans a bad idea?

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At first glance, borrowing from your life insurance policy might seem like a good idea if you discover you do not have enough money in savings to meet a financial emergency. After all, you may have been paying into it for years and the ability to secure a quick cash loan was possibly a key feature that sold you on permanent life insurance in the first place.

Although your whole life or universal life insurance policy may appear a tempting source for dealing with a crisis, before you take a life insurance loan, consider the risks should you neglect to pay the interest on your loan — or worse, trust that the dividends from your variable universal life policy will automatically cover the advance.

Remember, as with homeowners or auto insurance, life insurance has a larger purpose as part of an overarching financial strategy unique to each person’s life situation and financial goals. You are likely to find that you may have much better options, such as opening a home equity line of credit (HELOC) or taking out a personal loan.

What is a cash value?

Cash value is a specific portion of your life insurance policy that earns interest and remains separate from your death benefit. As such, the segregated cash value is available for a loan. There are several common life insurance products that will give you the option of creating cash value:

  • Whole life insurance policy — sets a fixed monthly premium over the life of the policy with a guaranteed death benefit. Cash value automatically builds up at a minimum guaranteed rate.
  • Universal life insurance policy — offers additional flexibility to have a monthly payment divided into two parts: One covers life insurance and the other goes into savings and investment to help build cash value.
  • Variable universal life — combines a death benefit with a savings account that allows you to invest in stocks, bonds and other vehicles you choose. You can grow your policy more quickly but also take on the risk of an investor.

The pros and cons of life insurance loans

There are certainly benefits to having ready access to a source of funds in the event of an emergency. Problems can easily develop however, when loans are not carefully monitored and lapse or when loans are taken simply in the ordinary course for everyday living purposes.

Pros

  • Tax benefits — Cash value loans are tax free. Your money will continue to grow tax deferred in your policy account based on cash value terms and potential dividends invested which can increase the growth of your total cash value.
  • Not your standard loan — You are able to pay back your cash value loan at any time in any manner — annually, monthly or quarterly. In fact, unlike a conventional loan, you do not have to pay back a policy loan at all. Any money you borrow will simply be deducted from the death benefit that goes to your beneficiaries.
  • Your credit is not impacted — You can borrow at any time, for any reason. No credit check, application or qualification is necessary. The loan is a private matter and does not appear on your credit report.

Cons

  • Costs to consider — Just as with a conventional loan, you’ll be charged interest ranging anywhere from 5% to 9% on the loan, says Al Barnes, a life insurance specialist in Alabama. Unpaid interest will be added to your loan amount and will be subject to compounding.
  • Unpaid interest can cause trouble — If you pay your loan interest out of your pocket, risks are minimized. But if you instruct your insurer to pay your loan interest with dividends or by dipping into your policy, you could be headed for financial difficulty. Any unpaid interest will accrue as income and be added to the loan balance.
  • Unintended consequences for policy beneficiaries — In the event that you unexpectedly die before your policy loan is paid, the entire balance of the loan plus any accrued interest will be taken out of the death benefit intended for your beneficiaries.

Frequently asked questions

What is the best life insurance company?

Life insurance is a common part of many financial plans for caring for the people in your life who depend on you. There are many excellent life insurance companies and you will want to select one with which you feel meets your personal and financial goals. Some of the factors to consider in your search include:

  • Breadth of product offering
  • Financial strength
  • Customer services
  • Policy price and value
  • Claim handling

How much life insurance do I need?

If your goal is to establish an inheritance for relatives or leave an amount for charity, you would need to buy the amount necessary to reach those goals. Each situation differs, but many people want to leave enough through a life insurance policy to maintain the support currently provided for dependents. To help determine the amount of life insurance you will need for this purpose, financial experts typically recommend factoring in other sources of income that will support your dependents, such as Social Security or investments.

Which is better: term or whole life insurance?

Each type of policy can be important for different reasons to help you achieve separate goals. If your primary goal is to leave a certain amount for dependents, a term policy is widely considered the simplest and least expensive solution. On the other hand, a more expensive whole life policy may be right for you if your goal includes building up equity which you may access during your lifetime, or if you simply prefer a guaranteed payout for beneficiaries no matter the age at which you pass.