Some life insurance policies give you the option to take out a loan. Most of these policies are some version of whole life insurance, but there are a handful of term-life options that allow this choice as well. Before proceeding with the pros and cons of borrowing from the policy, it is important to see if this option is available to you in the first place.
If you do have a loan provision, then the amount of cash value that you build up in it will dictate how much money you can borrow. Using the policy to take out an emergency loan might seem like a risk-free idea to pay off some debt, but there are several financial implications to review with this decision.
You might find that there are some advantages over carrying credit card debt, student loans, or a car payment by creating this loan. There are also times when you can cause yourself even more harm because this is a lending product that creates another obligation. You’re taking on more debt to pay off older accounts.
Explore all of your options when reviewing the pros and cons of borrowing from life insurance to pay off debt.
List of the Pros of Obtaining a Life Insurance Loan
1. Obtaining a life insurance policy loan is fast and easy.
If you decide to borrow from life insurance to pay off debt, then the lending product you receive has very few hoops that you must jump through to obtain funds. You are borrowing against an asset you already control. That means there is no approval process to worry about with most policies. You don’t need to go through an income verification process or endure a credit check. Since you’re the one taking all of the risk since the policy itself serves as collateral, there are low interest rates, closing costs, and fees.
Once you request a loan from your life insurance, a check is usually in your hands in two weeks or less. There is no application process. Just fill out the form and get the money.
2. You can use the money for anything.
There are no stipulations that you need to follow when you decide to borrow from your life insurance. You can use the funds from your policy loan for anything. Since the policy’s cash value is collateral, you can pay off debt or go on a family vacation. Your insurance provider doesn’t need an explanation of how you intend to use the money. There are no monthly payment requirements or a payback date to worry about either. The loan accrues interest that gets added to its balance, but you can go for years without paying it back.
“If you are going to get thrown out of your house because you lost your income and can’t pay the bills, then using life insurance may well be better than taking on high-interest credit card debt,” says Bob Wander, a financial advisor in New York City. “It is still a yellow flag that a larger problem exists with your finances… If you need the money, it may be the best of the worst options, but generally it is a sign of a bigger problem.”
3. The amount that you borrow from life insurance is not taxable income.
When you decide to take out a policy loan from your life insurance policy, then the amount that you receive is usually not taxable income. The only stipulation on this advantage is that the amount must be equal to or less than what you paid in premiums. Your loan doesn’t hit your credit either and you’re borrowing against a personal asset. That means the IRS won’t recognize the loan as income under the current tax rules in place.
It is essential to remember that the laws regarding income designation can change from year-to-year, so this advantage must be verified periodically to ensure that it is still a possibility.
4. You’re not required to make a loan payment in most situations.
Because you’re borrowing from an asset you already have, most insurance companies don’t require a repayment program right away. You can let the loan sit for months, or even years, without sending any money back to pay off the obligation. That’s why some households look at this option for paying off debt. You can reduce balances immediately, improve your credit score, and even qualify for other traditional lending products like a mortgage by clearing these obligations.
There are financial risks to consider with any lending product, so you’ll want to speak with a professional advisor about what debt management options make the most sense for your needs.
5. The interest rates are significantly lower when taking this action.
There are times when paying off debt with a life insurance loan makes sense. If you carry a lot of high-interest credit cards or lending products, then the lower rates that you’ll receive with this advantage could save you thousands of dollars over time. Most products in this category offer an interest rate in the range of 5% to 8%. Even if you have excellent credit, your APR on one of those cards is going to be higher than 10%. Since you also get to repay the loan on your schedule, the cost savings that you achieve over time can go directly into the repayment schedule you set up for yourself.
Prudential has a 2% interest rate if the policy has been in place for less than 10 years. If you have one that is older, then the rate is just 1.05%.
6. Your credit report stays clean.
When you take out a life insurance policy loan, then the funds come to you through a different process than what a traditional lender offers. Your money doesn’t show up on your credit report. That means the impact to your credit score will be positive if you use the funds to pay off debt. If you were to consolidate your debt with a bank loan or a low-interest credit card, then the changes to your credit profile would likely lower your score. Keeping your credit report clean can help you to repair issues, clear collection accounts, and take care of obligations that are hanging over your head otherwise.
7. It could lower your death benefit below a taxation threshold.
Permanent life insurance without cash value is the best choice for households that want to avoid or reduce estate taxes for their heirs. If your estate is worth more than $11.4 million as an individual or $22.8 million as a married couple, then estate and inheritance taxes become part of the equation. Some states impose their own taxes as well, such as Oregon where the exemption is as low as $1 million.
When you decide to take out a loan to pay off debt, then your life insurance death benefit could lower below the necessary threshold. This situation is financially complex based on how the classification of the outstanding loan would be within your estate. It could provide you with an opportunity to get below some of the taxation thresholds that would impact your family after you’re gone.
8. You can still earn dividends through your life insurance policy.
Policy owners who have a whole-life product and participate in a dividends program can still earn this amount each year after taking out a loan. You do not usually receive a 100% loan for the cash value since missing one payment could result in the policy lapsing. That means you’ll still earn dividends in if eligible to do so. The amount you receive each year will likely be lower since most companies transfer the collateral amount to a secured account. You still keep the option of growing your death benefit or increases the cash value of your product.
It is important to remember that dividends are not guaranteed. They are usually awarded based on the operating performance of the insurance company. That includes expenses, claims, and investment earnings.
9. Interest stops accruing on the loan when you die.
There is no requirement to pay back a loan from the cash value of your life insurance policy. When you die, the collateral goes to the company. Then your heirs receive whatever remainder exists for the balance of your benefits. Even if you have an outstanding balance, no more interest goes against the amount taken once you die. Your loved ones will need to send in a death certificate to manage this issue, but it can be a way to pay for long-term medical expenses or additional healthcare needs as you progress further into retirement. As long as the figure doesn’t exceed the size of your cash value, you should be able to minimize some risks here as you take care of some debt obligations.
List of the Cons of Obtaining a Life Insurance Loan
1. You reduce the death benefit from your life insurance.
When you decide to take out a policy loan to pay off debt, then the amount that you receive goes against the death benefit that your recipients would receive. Any interest that remains on the balance also gets taken out from that amount. If your beneficiaries need the entire amount of the intended benefit to cover your final expenses, then an unpaid balance could be an unpleasant surprise for them. You have plenty of time to pay the money back, so it helps to do it, even if you can only send a little at a time.
2. Interest continues to accrue with or without payments.
You have the option to pay back your policy loan right away to restore a 100% death benefit. There is also the ability to sit on your loan for years without making a single payment. If you were to take the latter option, then interest would continue to accrue on the account, adding to the final amount you’d need to repay. Most insurance companies will transfer the interest to the principal balance of the loan without payments too. This disadvantage means that you could be repaying a significant amount more than what you initially borrowed to pay off debt when you look at your long-term finances.
3. There can be tax complications in some situations.
It is possible for the loan balance from a life insurance policy to increase above the cash value of the account. This disadvantage occurs if someone decides to leave the loan open without any payments over a significant time period. When it occurs, then your policy could lapse because the insurance company sees it as worthless. You could be asked to surrender it as well. The loan balance and any interest would then be considered taxable income by the IRS. You would owe taxes on that figure based on when it became income for you, which means you could be liable for a significant amount.
4. Borrowing from your cash value could decrease the dividends you receive.
If you take a policy loan from your life insurance, then the cash value that you borrow might move your funds to a secure account. Providers take this action because money in an investment account is at a higher risk of being lost. The insurance company wants to make sure that you can take care of your collateral obligation with this move, so that means any dividends earn on your investments through this policy will go down. If you’re borrowing against the entire policy, then you might not see any growth happen until you repay a majority of the funds you took to clear the debt.
5. You can only take out one loan at a time.
When you take out a loan for your debt obligations, that is the only lending product that your insurance agency typically provides. If you run into a monetary emergency in the future, then this option won’t be available to you unless you’ve paid off the first obligation. This disadvantage might not apply if your first loan was only a fraction of the cash value that you’ve built up into the policy. If there are other ways that you can take care of your debt without taking on more of it, then that solution is usually going to be the better one. Some companies won’t let you borrow anything else until the first obligation is repaid.
6. It can take a lot of time to build up enough cash value for a loan.
Since most life insurance loans come from universal or whole-life products, you’ll be paying a premium for several years before you have enough cash value to borrow against. It is not unusual for 10-15 years of on-time policy payments to be necessary before you can start taking advantage of this lending option. Then the amount you can receive is based not on the death benefit, but the scheduled cash value based on the timetable for your policy. If you have a $50,000 plan, you might have a cash value of $1,000 after four years of on-time payments. You must keep this disadvantage in mind when looking at borrowing options to ensure that what you receive can take care of your debt.
7. There could be several hidden costs in your agreement.
Before you decide to move forward with a life insurance policy loan, it is essential to have a serious discussion with an insurance provider or financial planner. There could be several hidden costs to the transaction that you may not realize initially. Do you need to pay an opportunity cost to access these funds? Will there be a direct impact on the benefits that your life insurance policy would pay?
Do you have the ability to pay the interest and other fees that come with this financial action? You may discover that the amount you qualify to receive isn’t worth the cost it takes to get a check in the mail to pay off some debt. Northwestern Mutual charges a 2% additional debt expense charge in addition to a 5% annual interest rate for these loans.
8. There are limitations to the amount you can borrow.
How much you can borrow from your life insurance policy depends on the insurer and your agreement. The maximum loan is typically about 90% of the cash value of your product. Most policies do not require you to borrow a minimum amount. If you have more collateral in the policy, then you have the option to receive more. This issue is the reason why you should carefully monitor the status of your loan. Interest compounds faster than you might realize, so you’ll need to monitor its size compared to the cash value of your asset to ensure that it doesn’t have the chance to lapse.
9. You may not have this option.
If you’re in the first years of establishing a life insurance policy, then there may not be any cash value that you can use to obtain a loan. It is not unusual for people to think that what they’re borrowing against is the death benefit. That’s not the case. Your insurance company will charge the death benefit for an outstanding loan if you die because your estate becomes responsible for your affairs at that time. Without any collateral to use, you’ll need to look for a different option if you have debts that are demanding your attention.
10. Some insurance companies have specific rules you must follow.
There are times when term-life policies can qualify for a loan, but it is usually only when the individual in question has a terminal diagnosis. You might find a lender willing to work with you if the policy is more than $100,000, but then you’d be required to change your beneficiary to the lender instead of your loved ones. The problem here is that any way you go, there is going to be a reduction in benefits that you experience. You’ll benefit by having more money today, but your estate will be lacking in funds if something unexpected happens to you after taking care of your debt.
The pros and cons of borrowing from life insurance to pay off debt provide a basic list of discussion points to discuss with a licensed representative or advisor. Making an informed decision about your finances will help you to know if this is an intelligent way to clear some obligations. There are some benefits that might be helpful, but there are also significant risks when taking this action without careful planning.
Borrowing from your policy when you’re enduring a difficult financial period could result in cash that is no longer protected from your creditors. The value in your life policy is protected if there isn’t a loan on the product.
Always look at the big picture before deciding on this option. The act of borrowing from your life insurance is not the same as taking money out of your savings or checking account. It is a complex move that requires you to understand every element of it.
Blog Post Author Credentials
Natalie Regoli, Esq. is the author of this post and the editor-in-chief of our blog. She received her B.A. in Economics from the University of Washington and her Masters in Law from The University of Texas School of Law. In addition to being a seasoned writer, Natalie has almost two decades of experience as a lawyer and banker. If you would like to contact Natalie, then go here to send her a message.