Are life insurance loans a bad idea?

One of the advantages of purchasing permanent life insurance is the accumulation of cash value. While you are still alive, you can borrow from or withdraw from this savings account. Although borrowing from life insurance may be appealing, it may reduce the death benefit if you do not repay the loan in full before you die. Consider the pros and cons of life insurance loans before deciding if it's in your best interest to do so. If you want to ensure that your beneficiary receives the full death benefit, you should consider tapping into your savings, taking out a personal loan, or opening a home equity line of credit (HELOC).

How do I take a loan from my life insurance policy?

To take out a loan from your life insurance policy, you must first have the appropriate policy. Permanent life insurance policies are the only type of life insurance that can be used to obtain a loan. A cash value savings account is included as part of the policy. Each premium payment will be deducted from the cash value account by the insurance company. The cash value will grow tax-free and with interest over time. The rate at which it grows is determined by the type of permanent life insurance policy you have:

  • Whole life insurance policy: A whole life insurance policy has a fixed monthly premium for the duration of the policy and a death benefit that is guaranteed. Cash value accumulates automatically at a minimum guaranteed rate.
  • Universal life insurance policy: Universal life insurance policies provide additional flexibility by dividing monthly payments into two parts: one for life insurance and the other for savings and investment to help build cash value.
  • Variable universal life: Combines a death benefit with a savings account in which you can invest in stocks, bonds, and other vehicles of your choice. You can expand your policy more quickly, but you must also accept the risk that comes with becoming an investor.

You can borrow against your policy once you reach a certain cash value balance determined by your insurer. A life insurance loan does not require a credit check or an application process. You ask the insurer for a loan amount, and they set up the loan and determine the interest rate. There are no fixed repayment terms, as there are with a bank loan.

Although you are not required to repay the loan, it is prudent to do so. If the amount owed exceeds the cash value account balance, the policy may lapse if it is not repaid. If you die before repaying the loan and interest, the remaining balance will be deducted from the death benefit amount owed to your beneficiary.

What is cash value?

The cash value of your permanent life insurance policy is a portion of it that earns interest and is separate from the death benefit. When you purchase cash value life insurance, your premium covers the cost of insurance as well as overhead and fees. The remainder is deposited into your cash value account.

You can access the account to use while you're alive once you've accumulated enough cash value (as determined by the insurance company and policy type). Cash value can be used to pay premiums, make a loan, or make a partial withdrawal. If you no longer require the death benefit, you can sell the policy for cash or surrender it for the cash surrender value.

Remember that, while money borrowed from your cash value account that is not repaid will reduce your death benefit, the cash value account is not part of your death benefit and will most likely be returned to the life insurance company when you die.

The pros and cons of life insurance loans

Before signing any loan agreement, there are advantages and disadvantages to consider. Life insurance loans are no exception. There are some advantages to taking a loan from your cash value, but there are also some disadvantages that may indicate you have better options elsewhere. Consider these life insurance loan pros and cons before making a final decision, and consider consulting a certified financial planner to ensure you make the best decision 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 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 will lower your death benefit when claimed.

Interest will accrue and can compound: The insurance company determines the interest rate when you take out a loan, 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.