With a permanent life insurance policy, you earn cash value over time. Cash value is the portion of your premium that the insurance company invests over time. You can typically access this cash value through policy loans and withdrawals. Since your cash value is used as collateral, the interest rate on a policy loan may be lower than what you’d find with a personal loan or credit card. Some states limit how much the insurer can charge in interest. For instance, Washington state has an 8% annual limit; in Florida, the annual rate can be no higher than 10%. If you decide to take out a policy loan, the insurance company will give you the cash you need. In exchange, you’ll agree to repay the loan plus interest. Unlike traditional loans, you won’t have a set repayment schedule with a policy loan. You can choose to repay the loan as quickly or slowly as you like. Remember that the longer it takes to repay the loan, the more interest you’ll owe.
Example of Taking Out a Policy Loan
Let’s say you have a life insurance policy with a $200,000 death benefit and a $35,000 current cash value. You take out a policy loan of $21,000 at 7.5% interest to help pay for your child’s college education. However, you unexpectedly pass away three years later, before making any loan payments. Since interest accrues on policy loans, the outstanding loan balance would have grown to $26,088 since it originated. That’s the original $21,000 plus $5,088 in interest. The insurance company would deduct that amount from your beneficiaries’ $200,000 death benefit. So instead of getting $200,000, they would only get $173,912.
Pros and Cons of Taking Out a Life Insurance Loan
Pros Explained
No credit check: Since the insurance company uses your cash value as collateral, a policy loan doesn’t require a credit check. That could be beneficial if you have bad credit or are worried about the impact of a hard inquiry on your credit score. Repay on your schedule: Most policy loans don’t have a set repayment schedule where you must pay equal monthly installments. Instead, you can repay the loan in a way that works for you. You can also choose not to pay it off and just let it get taken out of your death benefit when you pass away. This flexibility can help if you have a tight budget. Spend the money however you’d like: Policy loans don’t restrict how you can spend the money you borrow. You can use it for anything, whether it’s to cover an emergency expense or pay for a large purchase.
Cons Explained
Could cause your policy to lapse: If you don’t repay a policy loan, it continues to accrue interest. Over time, the balance increases and can get much higher than you thought. Your policy could lapse if you don’t have enough cash value to cover the loan balance and interest. That would leave you without life insurance coverage. Can have severe tax implications: If your policy lapses or you surrender or cancel it before paying back your loan, the IRS might consider the money you borrowed to be income if it is more than you paid in premiums. This can leave you with an unexpected tax bill. May reduce your death benefit: Any outstanding balance is taken from your death benefit when you pass away. A reduced benefit means your beneficiaries won’t get all the money you’d planned to give them.
