Are life insurance loans a bad idea?
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Key takeaways
- Life insurance policies can sometimes be used as collateral for loans, allowing policyholders to access funds without cashing out the policy.
- Life insurance loan interest rates are typically lower than other types of personal loans, often between 5–8 percent.
- Loans against life insurance typically reduce the death benefit that beneficiaries would receive, so it’s important to weigh the tradeoffs before borrowing.
Borrowing against your permanent life insurance policy may seem appealing, but it has tradeoffs. While policyholders can access their cash value through loans, this typically reduces the death benefit that beneficiaries receive if the loan isn’t fully repaid. Given the impact on your legacy, it’s important to weigh the pros and cons before taking out a life insurance loan. This decision matters because you may have better options to access funds, like savings or other low-interest loans, that don’t put your policy’s payout at risk.
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Whole life insurance combines life insurance with an investment component.
- Coverage for life
- Tax-deferred savings benefit if premiums are paid
- 3 variations of permanent insurance: whole life, universal life and variable life include investment component
Term life insurance is precisely what the name implies: an insurance policy that is good for a specific term of time.
- Fixed premium over term
- No savings benefits
- Outliving policy or policy cancellation results in no money back
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The pros and cons of life insurance loans
Before borrowing against your life insurance policy, carefully weigh the pros and cons. While loans against cash value offer some benefits like low life insurance loan interest rates, they also reduce the death benefit passed on to beneficiaries if not repaid in full. This potentially huge downside means you should explore alternatives first, like liquid savings or other low-rate personal loans that don’t put your legacy at risk. A financial planner can help analyze if a life insurance loan makes sense for your situation.
Life insurance loans pros and cons
| Pros | Cons |
|---|---|
| Tax benefits: Cash value grows tax-deferred, and if you take a loan, it is tax-free, though interest will accrue. | Death benefit could be reduced: If you don’t pay the loan amount and interest back in full before death, the outstanding balance will typically reduce the death benefit amount your beneficiary will receive. |
| No set payment terms: Unlike a traditional loan, there are no set repayment terms. You can pay back the loan monthly, quarterly, annually or decide not to pay it back at all, though this would lower your death benefit when claimed by your beneficiaries. | Interest will accrue and can compound: The insurance company determines the life insurance loan interest rate, which can be anywhere from 5 to 9 percent. Unpaid interest can compound, causing the loan balance to grow if not paid down. |
| No credit check: There is no credit check or qualification process. Even if you have poor credit or no credit, you can still take a loan against your life insurance cash value. | The policy could lapse: If the loan grows beyond the cash value account balance, it could cause the policy to lapse. If the policy lapses, there will be no death benefit for your beneficiary when you pass away. |
How do life insurance policy loans work?
Cash value is a key component of permanent life insurance policies that enables policyholders to access funds through loans. A portion of premium payments go toward building cash value, which accumulates interest separately from the death benefit. After a set period of time, often 2–3 years, the insurance company allows policyholders to borrow against this cash value if certain conditions are met.
The loan amount available depends on how much cash value has accrued. Insurance companies typically only allow loans up to a percentage of the total cash value to ensure the policy stays in force. Any unpaid loan balance typically gets deducted from the death benefit payout to beneficiaries. However, the cash value itself remains owned by the insurance company and does not get distributed to beneficiaries after death.
Understanding that policy loans use cash value rather than the death benefit is key to weighing the tradeoffs. While policyholders get access to funds, they potentially reduce the legacy left behind if the loan isn’t fully repaid.
How do I take a loan from my life insurance policy?
To take a loan from your life insurance policy, you must first have the right type of policy. Permanent life insurance policies are the only type of life insurance you can take a loan from. Part of the policy is a cash value savings account. The insurance company will take a portion of each premium payment and add it to the cash value account. Over time, the cash value will grow, tax-deferred and with interest. How fast it grows depends on the type of permanent life insurance policy you have:
- A 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.
- A 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.
- A variable universal life policy 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 quicker, but also take on the risk that comes along with becoming an investor.
Once you reach a certain cash value balance determined by your insurer, you are eligible to take a loan against it. There are no credit checks or application process to take a life insurance loan. To take one, you request a loan amount from the insurer and the insurer sets up the loan and determines the life insurance loan interest rate. There are no set repayment terms like with a bank loan.
Although you don’t have to pay the loan back, it is wise to do so.
Do life insurance policy loans have to be paid back?
Yes, life insurance policy loans generally need to be paid back, though there is some flexibility in how repayment may occur. Policyholders are generally expected to repay the loan principal and interest during their lifetime. This allows the full death benefit to remain intact for beneficiaries.
If you don’t pay back a life insurance loan and the combined loan and interest exceed the death benefit amount, it could cause the policy to lapse without any payout to beneficiaries. The unpaid amount will typically be deducted from the death benefit payout when the policyholder passes away, technically “repaying” the loan by reducing what beneficiaries receive.
Frequently asked questions
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The best life insurance company is one that meets your coverage needs and other factors that are important to you. Although policy price is important, there are other factors to consider, like customer claim satisfaction or available riders to customize your policy. Consider reviewing the company’s financial strength rating, which shows its historic ability to pay life insurance claims. Once you determine which companies fit your desired profile, get quotes to compare so you can find the carrier with the best value for your coverage needs.
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How much life insurance you need depends on several variables. If you have dependents, how many years of income replacement do you need? Are you the breadwinner or a dual income family? If your spouse stays at home to raise the children, do you want them to remain in that role? Do you want your beneficiary to continue the same lifestyle? If so, for how long? Answering these questions can help you determine your coverage needs. You can also use a life insurance calculator and speak with a financial planner to help you determine how much life insurance to buy.
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When deciding between term versus whole life insurance, consider your coverage needs. Are they temporary needs, like paying off debt, or permanent needs, like paying for final expenses? Many people turn to term life insurance because it’s cheaper, but it only lasts for a set number of years. While whole life insurance is more expensive, it lasts for your lifetime and has guaranteed level premiums. You may decide one policy is better than the other to meet your needs, or find that a hybrid approach is best to cover all your life insurance needs.
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Interest accrued from a life insurance loan goes back into the company’s general fund.
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