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Many people buy life insurance to provide money for their families to use when there’s a loss of income after death. However, certain types of life insurance also offer the ability to take out a loan against the policy while the policyholder is still alive.
Life insurance policy loans have major advantages over bank loans or credit cards, but they are still loans — and if you don’t pay them back, there are consequences.
What is cash value life insurance?
Unlike term life insurance, which pays out only if you die during the policy term, permanent life insurance policies — sometimes called cash value life insurance — pay out no matter when you die. Part of your premium goes into a separate account that builds up cash value.
When there’s enough cash value, you can use it to:
Buy more coverage to boost the death benefit.
Withdraw cash. If you don’t repay the money, the death benefit is reduced.
Borrow money from the life insurance company. The cash value is used as collateral. Just like withdrawing cash, if you borrow against your policy and don’t repay that sum, your insurer will lower the death benefit amount.
Getting cash, no questions asked
Whether you need money to pay a medical bill or your kid’s college tuition, a loan against life insurance cash value has some advantages over credit cards or personal loans.
Advantages of a life insurance policy loan
No credit check
Low interest rates
Life insurance policy loans likely have lower interest rates than bank loans or credit cards. According to November 2022 data from the Federal Reserve:
No timetable for repayment
Policy still eligible to earn interest and dividends
While the insurance company will charge you interest on policy loans, you’ll continue to receive dividends or interest on the amount of money you borrowed — though at a lower rate than on non-borrowed funds.
Disadvantages of a life insurance policy loan
Any method of getting quick cash has drawbacks, and life insurance loans are no exception.
May not be available
It can take many years to build up any significant cash value in a permanent life insurance policy. In the early years of the policy, there may be little value, if any, to borrow against.
Risk of reduced payout
The death benefit will be reduced If you don’t repay the loan during your lifetime.
Risk of losing coverage
Possible tax consequences
You could owe income tax on some of the money you haven’t paid back if your policy lapses before the loan is fully repaid. There are nuances: You’ll be able to recover your policy’s “cost basis,” which is usually the sum of premiums paid on a tax-free basis. Anything received over the cost basis is subject to income tax.
Should you borrow from cash value life insurance?
A loan against life insurance could be a good alternative to running up a credit card balance or paying exorbitant interest on a personal loan.
Approach any loan from your life insurance company carefully:
Keep an eye on the interest accruing on your loan.
Set your own schedule for repaying the loan.
Stick to the plan to repay the loan. If you don’t intend to repay the loan, consider taking out a cash withdrawal to avoid dealing with interest.
Before taking out a policy loan, request an in-force illustration from your life insurance company. This document will outline the way the loan will impact your policy’s future performance. If you do take out the policy loan, request an in-force illustration every one to two years to monitor performance.