If you ever wondered how do life insurance loans work, you aren't alone. In fact, I got a call today from a policyholder who was thinking about borrowing some money from his policy. But, like a lot of people, he wasn't sure how borrowing against his cash value worked and he had some questions. It reminded me that I hadn't written about policy loans yet. I thought it would make a good topic to explain since so many people have questions about it.
What are Life Insurance Policy Loans?
Permanent life insurance policies build a cash value. As that cash value starts to build, if you want the money, you only two choices. The first option is to cash the policy in. But if you do that, then you lose your life insurance for good.
The second option is that the insurance company will let you borrow a portion of that cash value. The advantage here is that you can keep the life insurance policy in force but still use some of the money for whatever you might need it for. That way your beneficiary would still receive something if you'd happen to die.
How Much Can I Borrow from my Life Insurance Policy?
The amount of money you can borrow depends on how much life cash value you have accumulated in your policy. Cash value only accumulates in a permanent life insurance policy. So if you have a term life insurance policy, you won't be able to borrow against it.
If you do have a permanent policy, the amount of cash value you have in your policy is a function of two things. The first is, how long have you had your policy. If you haven't had your policy very long, you won't have very much if any cash value built up yet and you won't be able to borrow any money. The longer you have it, the more likely you'll have cash value to borrow.
The second factor in how much you borrow is how much you pay in premiums. The larger your premiums, the larger the cash value will grow. The smaller they are, the less it will grow.
Combining the two factors, the longer you've had your policy and the larger your premium, the more you'll cash value you'll build up.
Each year, the life insurance company will mail you a statement that shows you much cash value you have.
While you can't borrow the full amount, you can borrow a large portion of it. Maybe 80-90 percent of the available cash value.
When you decide to borrow money from your policy, a quick call to the insurance company is all it takes to find out the exact amount. There's no need for a fancy life insurance loan calculator. You just call them up.
How Do I Pay the Loan Back? Do I Have to Pay It Back?
The great thing about a life insurance loan is that while you can pay the loan back, you don't have to pay it back. If you never pay the loan back, the insurance company will eventually get their money back when you die by subtracting it from the life insurance face amount.
But, while you don't necessarily have to pay the loan back, it's still a good idea to consider doing so for a couple of reasons.
The first reason is that after a loan is repaid, if you need to borrow it again, you could do that. The second reason is that if you have a universal life policy, an outstanding loan could underfund it. I've gone into greater detail about the problems with underfunded universal life insurance in the past.
I guess if you have a dividend paying traditional whole life policy, there is potentially another reason to pay the loan back. That is if you have a direct recognition policy that reduces your annual dividend while a loan is outstanding. I don't think that has as much impact as most insurance agents might think.
Even if you don't pay the loan back, one thing I'd be certain to do is to pay the interest on that loan each and every year.
Let's talk about the loan interest.
Make Sure You Pay the Loan Interest Each and Every Year
After a loan is taken out against a life insurance policy, you are then charged interest on the amount of money borrowed. The amount of the interest depends on the insurance company. Some insurance companies have fixed loan interest rates while others have variable loan interest rates.
What's common to all life insurance companies is that they do charge interest.
Each year around your policy anniversary date, the insurance company will send you a bill for the amount of interest due.
You want to make sure that you pay that interest. If you don't pay the interest, then it's added to your loan and capitalized. That's a fancy way of saying you'll have to pay interest on the interest.
The problem with doing that is that it could eat away at the cash value of your policy and cause your policy to lapse or terminate.
How Does a Loan Affect My Life Insurance Premium?
Your premium remains the same. It still needs to paid while the loan is outstanding. Otherwise, your policy will eventually lapse.
Avoid Borrowing Money from Universal Life Insurance Policies
If you have read any of my stuff, you know that I am not a big fan of universal life insurance policies. That goes double if you borrow against the cash value.
It's my opinion that a lot of universal life insurance policies are just a problem waiting to happen.
When you borrow against universal life policies (and if you neglect to pay the interest), I think that the universal life policy will just lapse sooner than it would.
I would limit my borrowing to only from whole life insurance policies. I would avoid ever borrowing money from a universal life insurance policy.
I wouldn't buy a universal life insurance policy in the first place.
Are Life Insurance Loans Taxable?
Loans from your life insurance by themselves are not taxable. Theoretically, I suppose if your life insurance policy lapsed with an outstanding loan, it might be taxable if the amount you had received from the loan was greater than the premiums you had put into it. As with all tax questions, check with your tax advisor.
Loan Repayment Tips
I don't have any stats, but it's my guess that the vast majority of people who borrow from their life insurance policy never pay it back. Of those, I'd be willing to wager that a large percentage don't pay the interest every year.
Keep in mind that you can pay the loan back at any time.
While the ideal system would be that you'd set yourself up on some sort of repayment plan, you might not be inclined to do that.
In it's place, what I suggest that you do is set up your online bill pay to send money to the insurance company automatically each time you get paid.
What Steps Do I Need to Take to Borrow the Money?
OK. So you decided to borrow from your life insurance. What's the next step. Just call up your life insurance company and they'll take care of it. In most cases, if you are the owner of the policy, you can do it right over the phone.
There will be times, you might have to fill out some paperwork to get the loan. In most cases, this is just to verify that it's really you taking out the loan.
Once you've put in the request, most likely in a few days you'll have a check in your hands.
Hopefully, that helps answer your questions about how life insurance loans work. They can be a good tool if used properly. Try not to borrow from universal life insurance policies. Pay your interest each year and try to pay back your loan.
Have any questions I didn't answer? Let me know in the comments.
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