Life insurance is an important policy to protect your loved ones financially in case of a tragic event. But if your policy has a cash value to it, you can benefit by burrowing from it if the cash value is enough. The exact details of this vary based on your policy, its terms and your own life expectancy. This can be a very useful source of short-term liquidity when used wisely. But it comes at the cost of potentially higher premiums and a reduced safety net for your loved ones. We’ll discuss how it works.
A major part of any financial plan is life insurance. Talk to an advisor about your financial plan today.
What Is Life Insurance?
Life insurance is an insurance plan that provides cash and benefits in the event of the covered individual’s death. Only natural persons can get life insurance. This means you can’t buy an insurance policy for a corporation or other legal person. People typically use life insurance as a way to provide for their loved ones after their own death.
There are two main types of life insurance: permanent insurance and term life insurance.
Term Life Insurance
Term life insurance covers you for a period of time. For example, you might get a policy that pays out if you die some time in the next 10 years. This is more affordable, and it’s not uncommon for people to use it under specific circumstances.
For another example, a new parent might get a term life insurance policy for 20 years in case they die before their children reach the age of majority.
Permanent Life Insurance
Permanent life insurance covers you for your entire life. The premiums for permanent life insurance are usually higher than for term life insurance because. That’s barring lost coverage or medical miracles, this policy will pay out eventually.
However, that can be mitigated, potentially by quite a lot, depending on how early in life you get this policy. There are several types of permanent life insurance policies that range in benefits and costs depending on the individual’s needs.
What Life Insurance Policies Can You Borrow Against?
You can borrow against the value of your life insurance policy under certain conditions. Most, if not all, life insurance policies have the same basic requirements:
You Can Only Borrow Against a Permanent Life Insurance Policy
You cannot borrow against a term life insurance policy, only a permanent one. This is because the insurer uses your life insurance’s cash value and its policy as collateral for the debt.
If you don’t pay back the debt, they can take the money from your policy’s cash value and its benefits. Since a term life insurance policy has no cash value and isn’t guaranteed to pay out, these policies effectively have no guaranteed collateral.
The Policy Must Have a Cash Value
Cash value is a feature of certain types of permanent life insurance policies. Most notably, whole life insurance, universal life insurance and some variable life insurance policies offer this feature.
With cash value, a portion of your premiums is set aside in an account on your behalf. This is generally measured as the amount that your monthly payments exceed the amount necessary to guarantee your death benefits at any given time.
Cash management is one of the major differences between types of permanent life insurance policies. Each has a different way of setting the interest rate for your policy’s cash account. Some policies use your cash value to supplement your death benefits, while others use it to supplement your insurance premiums later in life. The nature of this value ranges.
In all cases, however, you can only borrow against a life insurance policy with existing cash value, meaning that your policy must both support cash value and must have money in the account.
How Do You Borrow Against Life Insurance?
The mechanics of borrowing from a life insurance policy differ based on your specific policy and insurer. But in general, each will have a specific form or point of contact that allows you to apply for this loan.
Borrowing against life insurance is not like most loans. You do not need to go through an approval process or a credit check because the loan is secured by, and limited to, its cash value and death benefits. For most, if not all, insurance policies you also do not need to provide qualifying reasons for borrowing against this money. This is unlike, for example, borrowing against a retirement plan, which typically is allowed only under specific circumstances.
Most insurance policies will allow you to borrow up to the current value of your policy’s cash account, or at least within 80% – 90% of this value. If you fail to make payments, or if your policy lapses, the insurance company will take payment from your policy’s cash account and collect any remainder from you directly.
If you still owe money at the time of your death and the cash account does not have enough to cover this debt, your insurance company will claim the remainder of your policy’s death benefits.
As with all loans, you do not pay taxes on the money you receive from a life insurance loan unless it is later forgiven.
Pros and Cons of Borrowing Against Life Insurance
There is the main advantage of borrowing against life insurance is liquidity. In a real way, you are borrowing from yourself, since you’re taking a loan against your own policy’s accrued value.
Interest rates are generally low. So you don’t need to provide additional collateral. And your insurance company can turn around the money quite quickly relative to many other forms of personal lending.
The downside is that borrowing against your life insurance policy reduces its value until you repay the debt. Your insurance company gets a claim against your policy’s cash value up to the current value of the loan (including all accumulated interest).
Bottom Line
You can borrow money against permanent life insurance policies that have cash accounts associated with them. With a standard life insurance policy you can borrow up to its cash value, but this will reduce the value of your policy until the debt is repaid. A life insurance loan can be a good source of short-term capital for specific needs. As with all loans, despite the low-interest rates involved, do not use this as a source of funds for investing.
Insurance Planning Tips
Your selection of an insurance policy can have lasting effects on your overall finances, especially once you reach retirement. A financial advisor can offer valuable help. Finding one doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Looking for a straightforward way to see how much insurance you need to buy? A free insurance calculator can give you a quick read on what would be right for you and your loved ones.
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The post How to Borrow Against Your Life Insurance Policy appeared first on SmartAsset Blog.
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