Category: General Info

Dangers of Policy Loans | Should You Borrow From Your Life Insurance Policy?


Borrowing from your life insurance policy might seem like a great idea if you find yourself in a tough situation. Nicole Wilson, a financial expert from Cash Depot Omaha shares financial tips and advice on using policy loans. Her purpose is to help you make smarter financial decisions.

When you purchased your insurance policy, the insurance agent may have mentioned how to borrow money from your own life insurance policy. Insurance agents and companies may advertise loans as a simple and easy way to get tax-free funds from your life insurance policy. However, such loans are not as easy as they might seem.

Policy loans need to be treated carefully. If you do not monitor a policy loan, a policy could worsen over time, and you could end up losing the minimum cash value needed to maintain coverage and the policy could lapse. Finally, you can find yourself in an unpleasant situation when you have to make a choice: whether making substantial loan repayments or having a large phantom income tax gain.

What Is a Life Insurance Policy Loan?

A life insurance policy loan is issued by an insurance company and uses the cash value of a person’s life insurance policy as collateral. You can usually take out loans against permanent life insurance policies, but not term life insurance policies. Policy loans differ from other loans. Customers are not required to repay these loans, but can choose to do so. Do not forget that you will be charged interest on your life insurance policy loan.

When you borrow cash from your policy, you are borrowing your own funds. It is actually a cash advance that you can receive from the policy through a surrender of the policy (the person who terminates the policy before its maturity), or such loans are borrowed against the death benefit. It is cash that you (or your beneficiary) would have received in any case. The insurance company uses the policy as collateral for the loan.

If you do not repay the life insurance policy loan, the amount is deducted from the death benefit when you die —meaning that you could face a lowered death benefit.

Oliver Wendell Holmes, an American jurist and legal scholar, wrote, “The so-called liability of the policyholder never exists as a personal liability, it is never a debt, but is merely a deduction in account from the sum the plaintiffs (the insurer) ultimately must pay.”

How Does a Life Insurance Policy Loan Work?

If you have permanent life insurance, you may be able to use your policy’s cash value as collateral to take out a loan. Term insurance does not have a cash value component, there is nothing to borrow. Generally, you get a loan amount equivalent to 80% of the policy’s surrender value. You will be charged interest on the policy loan.

To get a policy loan, you’ll need to visit the nearest life insurance company. Before applying for such a loan, make sure you understand the consequences. For this, you can request an in-force policy illustration, an estimate of how a life insurance policy’s cash value balance will change over time. An in-force illustration is an easy way to verify that one’s life insurance policy is performing as expected.

The in-force illustration projects the current costs of your life insurance policy from lapsing. It also discloses the terms related to interest: whether you will be paying interest on the loan out of pocket or if you will be borrowing interest as well.

Also, find out whether you will be charged interest in advance or in arrears.

Interest in advance

Interest in advance is when the insurer assesses interest for the entire year. This means you prepay interest on your policy loan for the year ahead. If you take the loan in the middle of a policy year, you will be charged interest for the remainder of the policy year at the time you receive the loan.

If you repay the loan during the policy year, you will not be provided any credit or refund on the interest you paid in advance.

Interest in arrears

Interest in arrears is interest that is due only at the maturity date rather than periodically over the life of the loan. Interest accrual is daily. If you take a loan in the middle of a policy year, interest starts to accrue that day. If you repay a loan in the middle of the policy year, the daily loan interest amount will lower, thereby reducing the interest due at the end of the policy year.

The interest rate on a life insurance policy loan can be variable or fixed. A fixed interest rate is a rate that doesn’t change for the duration of your loan, or at least for a specific period. A variable interest rate is one that can fluctuate over time, causing your loan payments to change.

Whole life insurance policies use the term “recognition” to describe how much interest is credited to the cash value that is lent. The life insurance company may use the direct or non-direct recognition method. Direct recognition is a strategy that insurance companies employ to deal with the loaned cash values of life insurance policies. With non-direct recognition, you are required to make interest-only payments every month, whereas a policy loan is totally flexible.

Whole life policies may also have an automatic premium loan provision, an optional provision in life insurance that authorizes the insurer to pay from the cash value any premium due at the end of the grace period. An automatic premium loan provision allows an insurance company to take a loan from the policy’s cash value to cover unpaid premium.

Stay informed that interest on a policy loan is typically not deductible for taxes.

How to Monitor a Life Insurance Policy Loan

You will not be required to pay off the loan balance. The insurance company will not provide any loan repayment schedule. You may either select to each year to pay loan interest out of pocket or to borrow the interest. If you opt for the latter, the loan balance will compound. Compound interest is the interest you earn based on your original amount of money and the accumulated interest.

It’s crucial to request an in-force policy illustration every year to understand the influence of a policy loan. The illustration can be incredibly useful in your financial planning. Your request should include the scenarios that reflect your plans, including:

  • Paying interest and premiums out of pocket;
  • Paying off the policy loan in full;
  • Taking a partial withdrawal;
  • Borrowing future premiums and loan interest;
  • Reflecting what happens if your current premium payments do not change;
  • Changing your dividend option, etc.

Why Is a Life Insurance Policy Loan Risky?

An in-force policy illustration can help you monitor the variables that impact your policy’s performance. You will see that the larger the amount borrowed, the more influence it will have on your insurance policy.

For example, if your initial policy loan is $50,000 and an interest rate equals 8%:

  • The loan interest in year 1 will be $4,000.
  • If the loan interest is borrowed, your loan balance would grow to $54,000 (initial loan amount of $50,000 + the loan interest of $4,000).
  • The loan interest in year 2 would grow to $4,320.
  • The loan balance would increase to $58,320 if you borrow loan interest again ($54,000 loan balance + the loan interest of $4,320).

Accordingly, this make the policy loan balance grow fast.

How to Calculate Taxable Income from a Policy Loan

We will describe how to calculate the potential gain in the life insurance policy that would be income taxable:

  • Add the net cash value, any dividends received and the outstanding loan balance.
  • Subtract the cost basis.

For example, if a life insurance policy expires with a loan balance of $100,000 and a $50,000 cost basis, the taxable gain would be $50,000.

Please keep in mind that the given example is average and may not be applicable to every situation. You’d better contact your tax advisor to learn whether your gain is taxable, to determine the cost basis. The life insurance company will also inform you about the gain that they will report to the Internal Revenue Service as 1099 income. Businesses and government agencies use 1099 forms to report various types of income to the Internal Revenue Service (IRS). All 1099 income is reportable and usually taxable.

As you can see, a life insurance policy loan can provide you access to fast cash, it can have several flaws. Weight all the pros and cons before you borrow cash.

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