Traditional loans from banks and other financial institutions are widely accepted for covering expenses that go beyond our financial means. However, this reliance on loans has created a credit society where many people find themselves constantly in debt.
Thankfully, there is an alternative way to borrow money through policies. Exploring this option opens us up to new possibilities and potential benefits. This article will discuss the benefits and important factors to consider when using policies as a source of funds.
The concept of life insurance loans
All it takes is a bad credit rating to complicate your financial life and trap you in a never-ending cycle of overwhelming debt. Limited access to credit cards, difficulties in obtaining loans, and higher interest rates become the roadblocks in your path. That is the frustrating reality of the conventional financial system. But is there a way out?
Insurance loans have been available for several decades, and the concept of insurance dates back as far as the 14th century, even before the establishment of banks. Despite their long existence, many people are still unaware of policy loans and the advantages they offer.
Life insurance explained
A Life insurance policy is a legally binding contract between an insurance company and a policyholder guaranteeing that the policyholder will pay premiums to the insurer in exchange for death benefits. These death benefits are sums of money the company pays to the policyholder’s beneficiaries upon the insured’s death.
Basically, a life insurance policy involves paying an amount of money to an insurer every year for a fixed term or the rest of your life so that you can support your loved ones long after you’re gone.
Both term and permanent life insurance policies offer this service to policyholders, but they don’t operate the same way. Term life policies are cheaper and cover a fixed period, e.g., eleven years.
But if the insured outlives the set period, they have to extend the insurance. Otherwise, the policy would lapse along with its death benefits. On the other hand, permanent life insurance covers the policyholder’s entire lifetime and can only lapse if the insured stops paying premiums or cancels the policy.
The idea behind life insurance loans
Though the core objective of life insurance is to save money for your beneficiaries to enjoy when you’re gone, some policies offer funds to assist you in the present.
There are cases where your immediate needs are more pressing than the desire to leave money for your beneficiaries or an unexpected financial burden that leaves you unable to pay your premiums. In such instances, you can borrow money from the insurance company rather than entirely quitting the policy and losing out.
This loan is drawn against your policy’s cash value, so the amount you can borrow depends on the size of your policy. You can then use the money to finance your expenses or even pay your premium with no pressure of a repayment deadline. Essentially, you’re buying death benefits for the future while still having access to money to fund your needs today.
For example, John pays an annual premium of $4,000 and has a current total of $600,000 in death benefits and $50,000 in cash value. Suppose he has a sudden medical expense of $40,000 and cannot finance it with his personal savings; he can borrow the $70,000 from his insurance company and choose to repay when he can. The loan would only be automatically deducted from the death benefits if he passes on without repaying it.
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When dealing with insurance loans, there are different types of policies to consider. The most important is the availability of a savings component. This component provides you with the cash value you use as collateral when taking out a loan. However, not all life insurance policies have this feature.
The cash value component is missing in term life insurance but available in most permanent life insurance policies like whole life insurance and universal life insurance.
Life insurance policy loans VS Traditional loans
Traditional loans are the popular form of borrowing, where individuals and businesses request money from banks, credit unions, and financial institutions. To obtain the loan, borrowers have to fill out an application, undergo credit evaluations, and, if approved, repay the loan over a specified period with interest.
Unlike this common method, life insurance loans are simply between you and your insurance company and are often seen as you borrowing your own money. Since your premiums have cash value and it is this cash value you’re borrowing against, you are essentially your own lender.
Differences between life insurance policy loans and traditional loans
| Traditional loans | Life insurance loans | |
| Collateral | Usually requires property or assets to secure the loan | The policy’s death benefit is the collateral |
| Interest rate | They are typically determined by market conditions and creditworthiness | The insurance company sets them, and are either fixed or adjustable. Interest rates are lower than traditional loans |
| Credit score | Loan details and payment history affects the borrower’s credit score | Loan details and payment history do not affect the borrower’s credit score |
| Repayment flexibility | Loans have set repayment schedules over a specific term | Policyholders repay on their own terms |
| Loan limits | Loans may have predetermined borrowing limits based on factors like income, credit history, and collateral value. | Loans allow borrowing up to the available cash value of the policy, which can increase over time. |
Benefits of borrowing from life insurance
Permanent life insurance policies offer numerous advantages that set them apart from traditional methods of obtaining loans. Here are a few key benefits:
- Quick access to cash:
Unlike traditional loan procedures that involve lengthy processes, credit checks, and various requirements, life insurance policies provide swift access to liquidity. You can obtain the funds from your policy without undergoing extensive checks or waiting for hours or days.
- No credit rating discrimination:
When borrowing from a life insurance policy, your credit rating doesn’t impact your eligibility. Unlike conventional lenders who heavily consider credit scores, insurance companies generally don’t place importance on your credit rating when providing policy loans. It means you can still access the required funds even with a lower credit score.
- Dividends:
Depending on your life insurance policy type, such as participating whole life insurance, you may be eligible to receive dividends. These dividends can be used to pay the policy loan balance, increase cash value, or be cashed out.
- Flexibility:
Insurance companies typically don’t inquire how you intend to use the loaned money. This grants you the freedom to utilize the funds for various purposes, such as paying off debts, covering medical expenses, funding education, making personal investments, or even paying estate taxes. The absence of strict restrictions on how you use the loan gives you greater flexibility and control over your finances.
How it works
Getting a permanent life insurance loan is straightforward and starts with, first of all, being eligible to own a policy.
Eligibility criteria
- Age: Typically, applicants between the ages of 18 and 65 are eligible. Some insurance companies may extend the age limit up to 80, but it’s important to note that premiums tend to increase with age, so it’s best to start early.
- Financial stability: Being financially stable with a consistent source of income is essential. Life insurance requires regular premium payments for a specific period or throughout your lifetime. Therefore, having a steady cash flow is necessary to meet these obligations.
- Accurate health disclosure: While pre-existing health conditions or an unhealthy lifestyle can impact premiums and coverage amounts, many insurance companies still offer coverage. However, misrepresenting your health condition can lead to severe consequences, including being blocked by insurers and potential legal ramifications for insurance fraud. Once blocked, it would be extremely difficult to get a life insurance policy again.
Once you meet these basic requirements, you can set up your policy. However, it’s important to note that additional eligibility criteria may still need to be met, depending on your chosen insurance company or policy type.
Steps to set up a life insurance policy
- Assess your current financial standing: Begin by evaluating your financial situation, including your income, expenses, debts, and future financial goals. Understanding your financial standing will help determine the appropriate coverage amount and type of life insurance policy.
- Determine your needs: Reflect on the purpose of the life insurance policy. Consider factors such as income replacement, debt coverage, educational expenses, and providing for your loved ones in the event of your passing. Once you know your specific needs, you can better understand the type of coverage and policy required.
- Compare and select the best insurance company: Research and compare different insurance companies to find the one that offers policies aligned with your needs. Consider factors such as financial stability, customer service reputation, policy options, and premium costs. Look for a company with a strong track record and positive customer reviews.
- Consult with your insurance agent and set up your policy: Engage with a licensed insurance agent who can guide and assist in setting up your life insurance policy. The agent can help you navigate through the application process, work with you to complete the necessary paperwork, including the application, and review policy terms and conditions thoroughly. They are also available to answer any questions you may have.
Steps to take out a life insurance loan
You’ve set up your policy, made premium payments, and now have cash value for the taking. But how exactly do you get this loan?
- Reach out to your agent or call the insurance company directly and ask for a loan.
- The insurance company checks your policy to see if you have the cash value to support the loan amount.
- The insurance company issues you the check without requesting additional information from you.
- You deposit the money into your account and use it as you wish.
Precautions & Risks of Life insurance loans
As with many things in life, taking policy loans has upsides and downsides. However, most of them are hinged on ignorance, so having a clear idea of how to manage your life insurance loans will help you maximize your policy and prevent you from making costly mistakes. Here are a few precautions:
- Know where the money is coming from
Borrowing against your policy and withdrawing from your policy are two different actions with different consequences. When you withdraw from a policy, it reduces the amount of death benefit available and affects its cash value.
It could also cause your premiums to increase in order to maintain the existing death benefits. If you are unable to meet the premiums, the policy is in danger of lapsing.
On the other hand, borrowing against your policy would not affect your premiums or death benefits unless you don’t repay the loan before your beneficiaries inherit the policy. So make sure you take a loan from the company and not make a withdrawal from your policy.
- Know the fees and associated costs
Life insurance loans, just like traditional loans, come with interest. Depending on the insurance company and your type of contract, the interest rate on the loan could vary between 5% to 8%.
A flat fee may also be paid upfront when you take out a loan. The interest also accrues on the loan, so if you leave your loan unpaid for a long time, the interest payable could become a sizable sum.
Some insurance companies also withhold dividends once you take out loans, so talk with your agent and read your policy documents to agree on the terms before it is enforced.
- Know the terms; Modified Endowment Contract (MEC)
A key term to look out for in your policy is the Modified Endowment Contract (MEC) limit. This contract makes your policy taxable and comes into effect once the cash value exceeds the Internal Revenue Service (IRS)’ contribution limits.
If you overfund your policy, it will become a MEC insurance policy which attracts taxes on your cash value and a penalty fee if you withdraw before age 59.5 years.
- Know the policy conditions
If situations change and you want to cancel the policy, it has varying costs. For starters, if the cancellation happens within the policy’s early years, the insurance companies might charge a fee for it.
The money you get in return is also subject to taxes, and you lose the death benefits associated with the policy.
Risks of borrowing from life insurance
- Policy termination
Borrowing money comes with risks, and one of them is losing the policy. When you take loans up to the extent that it no longer satisfies the amount of death benefit required to keep the policy in play, your policy could get terminated.
Also, if you surrender your policy, the outstanding loan becomes taxable. Once your policy gets terminated, getting another one again will be difficult.
- Accruing interest reducing cash value
Life insurance loans have lesser interest rates, but since they have no payment deadlines or schedules, it is up to the financial discipline of the policyholder to make the necessary repayments to keep enjoying maximum benefits. This flexibility in deciding when and how to pay off the loans leads to the danger of accumulating interest over time.
These outstanding interests can then significantly affect the cash value, especially if the policy is set up with a direct recognition insurance company.
- Reduced death benefits or taxable
When a loan is drawn from the policy’s cash value, it is often considered a loan from the policyholder’s money which is one of the reasons why there is no pressure to repay it.
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However, in the event the insured dies without repaying the loan plus interest, such monies are deducted from the policy, and any remaining balance is paid out to the beneficiaries.
How To Maximize Life Insurance Policy Loans
Insurance loans give you access to tax-free low-interest cash to spend on whatever you want. It gives you the freedom and opportunity to finance certain expenses that are profitable in the long run. Such as:
- Servicing your mortgage
Becoming a homeowner is an achievable dream when you make the most of your insurance policy. Rather than taking out a large sum of money from your savings annually to pay off your mortgage, you can borrow from the policy instead and use your savings to take care of your other needs. And you can use your savings to pay off the loan, and by paying off your loan with your savings, you’ve just money your money to the policy, which you can STILL access.
The policy would still grow and accumulate death benefits, cash value, and even dividends depending on the insurance company. You can also take out loans multiple times as long as the total does not exceed your premiums and there are enough death benefits to satisfy the insurance policy’s requirements.
For example, Kate has a mortgage debt of $280,000 for a tenure of 15 years at an interest rate of 5%. Suppose she has a life insurance policy with over $300,000 in cash value; she can borrow $280,000 against the policy to offset the loan in one payment instead of paying about $2,650 monthly to the bank for the next 15 years. Now she can repay her loan $2650 every month to replenish her loan balance and cash availability.
If more than her cash value is needed to clear it in one payment, she may also choose to borrow annually or as much as the cash value can cover. Insurance loans come with flexibility.
- Funding your retirement
Permanent life insurance policies can be seen as both an investment and an investment vehicle. For the former, you consistently pay your premiums and let your cash value accumulate throughout your working life. Upon retirement, you would have a substantial amount to borrow against and use without significantly harming your policy or the death benefits your beneficiaries would receive.
For the latter, you use the policy as part of an investment strategy to fund your other retirement plans, like your 401k. It’s important to consult your financial planner and agent to determine what is best for you.
In conclusion
With the right strategy, cash-value life insurance policies are the best vehicles for financial independence and wealth creation. Since the policy loans are easily accessible, tax-free, at lower interest rates, and flexible, you can convert your policy to a bank to finance your needs and accumulate interest via the infinite banking concept.
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