Whole Life Insurance Loan: Is It Wise to Borrow Against It?

Posted on February 21, 2021 in Loans

There are so many different ways to borrow money for anyone in need of a loan. From personal loans to home equity loans and even from credit card advances to loans based on retirement plans, the options can go on for a while. 

One of the lesser-known options for getting a loan is borrowing from an active life insurance policy. Although this decision will come with a few requirements, it can be a straightforward and quick way to get cash in hand.

What Is Life Insurance?

What exactly is life insurance anyway? While auto and home insurance are generally required by law, life insurance is optional. 

The way life insurance works is that the policyholder will pay a recurring amount of money, called the premium, to the insurance company. Should the policyholder die while the policy is still active, the insurer will pay out a tax free sum, called the benefit, to the parties dictated in the policy referred to as beneficiaries. Death benefits typically function as an income replacement so the beneficiaries can continue to afford housing, food, bills, etc. 

There are many different types of life insurance, though, and they can work in different ways, although the two main types are term and whole life.

Term Life Insurance

Term life insurance policies are generally considered the more simple and accessible life insurance policy options. The policyholder will pay the premium payments that will go to the beneficiaries in the event of death. The death benefit can be paid out as a lump sum, monthly payment or annuity although most people prefer just to take one lump sum payment. 

Term life policies last for several years before expiration and are also usually more affordable than other life insurance policies with lower premium costs. For example, the average monthly premium payment for a 20-year term and $500,000 policy for a healthy 35-year-old female is only $24.48. 

One of the downsides to term life insurance is that it can not be borrowed against. So while they are a reliable option for life insurance, they are not for loans.

Whole Life Insurance

Whole life insurance is considered permanent life insurance because it will never expire. 

Along with the typical death benefit, the cash value is also included, similar to an investment and tax-deferred savings account. The cash value will accrue interest at a fixed rate determined beforehand. Every month, a certain percentage of the premium will go into the policy’s cash value, which offers a guaranteed rate of return. This cash value will grow over time and eventually be used for loans if it accumulates enough value. 

One of the potential issues with whole life insurance is how much it will cost. It is relatively common for a whole life insurance policy to cost as much as five to 15 times as much as a term life policy for the same death benefit amount. Additionally, this policy will be much more complex than term life in terms of surrender fees, taxes, and interest because of the cash value option. 

The 3 Ways To Get Money Out Of A Life Insurance Policy

As stated previously, the only insurance policies that will permit loans are whole life insurance. This is because of the cash value benefit that is set up when taking out the policy. Although a little more complicated, the cash value essentially works like a savings account that accrues interest and accumulates value over time. 

Anyone that needs money now will have their choice of these three different ways to get cash out of their life insurance policy:

  • Withdraw Money

Some policies will allow the policyholder to make a tax-free withdrawal from their whole life insurance policy. However, should the withdrawal amount exceed the total paid into the policy’s cash value portion, it will be taxed as income. Additionally, withdrawing any cash value funds will reduce the death benefit paid to the beneficiaries in the event of death.

  • Take Out A Loan

Most all policies include the option of borrowing up to the total cash value of the policy. This loan would not be considered taxable income but would have to be paid back with interest. By accruing interest, this loan could decrease the policy’s death benefit. If the policyholder dies before repaying, then the outstanding loan would be subtracted from the death benefit.

  • Surrender Policy

This is essentially canceling a life insurance policy and dropping all coverage and benefits. When a life insurance policy is surrendered, the equity will be the amount paid into the account’s cash value portion plus whatever interest was accrued. There may be fees added in that will be taken from the total amount along with any funds to pay for unpaid premiums or loans taken on the policy. Also, the money received from surrendering the policy may be taxed as income.

How Do Life Insurance Loans Work?

Taking out a life insurance loan is a little bit more complicated than it may sound. 

Firstly there would not be any withdrawal from the life insurance policy itself or even the cash value. In fact, the money would come from the insurer, who would use the cash value as collateral on the loan. Like a traditional loan, the loan would be paid back with a predetermined interest rate, typically much lower than personal loans or credit cards, with the additional benefit of no mandatory monthly payments. 

While these parts of the deal sound excellent, they could come with some consequences should the loan not be paid back in a timely manner. The interest will be added to the balance and accrue whether the loan is being paid back or not, putting the loan at risk of exceeding the cash value. Should this happen, the life insurance policy itself could end up in jeopardy of being canceled.

When Are Life Insurance Loans A Good Idea?

When broken down to its bare definition, a life insurance loan is essentially just a secured loan using a bank account as collateral. Should someone get an auto loan and fall to pay it back, then their automobile would be repossessed. This is essentially how a life insurance loan works. There can be a few potential issues should the loan not be repaid, but the consequences are much less severe than alternative loans. 

Here are a few examples of when a life insurance loan is the best option:

  • Independent Beneficiaries

The whole idea of life insurance is to help those that remain in the event of the policyholder’s death. This would typically be children who are financially dependent on the policyholder. As they grow older and become independent adults, then the death benefit would be less and less necessary. 

If a retired couple has paid off their home and their children are financially independent, then a large death benefit would not be as important to maintain. Alternatively, younger parents with children living at home would want to keep the death benefit as high as possible for as long as possible.

Related: My parents are in so much debt

  • Poor Credit

One of the best benefits of this loan is that no credit is required. Similar to borrowing against a retirement plan, the borrower is essentially borrowing their own money, so credit will not impact the loan terms at all. Additionally, there will be no hard inquiry caused by checking the credit score, so there will be no negative effects there either. Poor credit can make getting a loan almost impossible, so this option can be a huge help. 

  • Payment Flexibility

Traditional loans come with a lot of terms. Set interest rates added in along set monthly payments for a set amount of time. Life insurance loans leave all of that up to the policyholder to decide. As long as the loan is repaid along with interest, then there are no penalties. 

The Takeaway

Life insurance loans can be greatly beneficial to individuals in times of economic struggle. Although not completely devoid of consequences, this loan type will be much more gentle than other options available. Borrowing against life insurance can be a smart way to get cash quickly.

Life insurance is a great idea for anyone with a family and loved ones, so spending the extra money to get a whole life policy can be a smart investment, especially when considering the possibility of needing a loan at some point. 

Other loans do not have the flexibility of repayment and require credit or collateral to accept. Life insurance loans are much easier to take out and less risky than other quick cash options. 

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