Most people buy life insurance to protect their families from the loss of their income if they were to die. However, certain types of life insurance offer the ability to take a loan against the policy.
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 a death benefit no matter when you die. Part of your premium also goes in a separate account that builds up cash value. Depending on your type of permanent life insurance, this cash value may be a part of your death benefit, or an addition to it. You can also borrow at least a part of this cash value, depending on the specifics of your policy.
Advantages of a life insurance policy loan
If you’re in need of emergency cash, you have a few options: You might apply for a personal loan from your bank or put expenses on a credit card. While both of these solutions have their places, a loan from life insurance cash value has a few big advantages:
- No credit check. If you have enough cash value in your life insurance policy, you can borrow from it, no questions asked. There’s no application process, unlike with bank loans. You simply fill out a form and receive a payment. And these loans don’t show up on your credit report, unlike credit card debt.
- Low interest rates. Personal loans have notoriously high interest rates, even at mainstream banks. The average rate on a two-year personal loan is 10.47%, according to the latest data from the Federal Reserve, and the average interest rate for a credit card is 13.68%. It’s very possible that your life insurance company will charge a lower interest rate than either option, though it’s always worth checking.
- No timetable for repayment. Unlike a bank or a credit card company, the life insurance company won’t come after you to repay your policy loan. You should absolutely repay it, but you can do it on your schedule. Be aware, though, that if your policy lapses before you fully repay the loan, you may end up owing tax on some or all of the portion you haven’t paid back.
Disadvantages of a cash value loan
Of course, any method of getting quick cash has drawbacks, and life insurance loans are no exception:
- Reduced death benefit. If you don’t repay your loan during your lifetime, it will reduce your death benefit. In some cases, this may be all right, but it could also put your family in a tough position.
- You’re limited by your cash value. It takes permanent life insurance policies years to build up any significant cash value. In the early years of your policy, you may have very little available to borrow, if any.
- You could lose your policy. Life insurance policy loans tend to have lower interest rates, but they do still have them. And because the interest is often simply subtracted from your cash value, it can sneak up on you. If your loan plus interest exceeds your policy’s cash value, the policy could lapse entirely, and you could face tax consequences.
So, should you borrow from cash value?
If you need to cover an unexpected medical bill or can’t pay your mortgage one month, a policy loan could be a good alternative to running up a credit card balance.
But loans from whole life insurance policies loans aren’t your only option. If you really need cash, you may be able to borrow from your 401(k) or IRA as well, though those loans have their own downsides.
If you think your family will need your full death benefit, approach any life insurance loans very carefully. Keep an eye on your accrued interest, and if your family needs the entire death benefit, don’t take a loan without a plan to pay it back.
Alice Holbrook is a staff writer covering insurance and investing for NerdWallet.
Image via iStock.