You can borrow against next week with a payday loan and against next month with a credit card. You can even borrow against your own retirement with a 401(k) loan. But what about a life insurance loan? Well, it won't affect your afterlife, but your heirs might not appreciate it. If you can get past that inconvenience, a life insurance loan may be a workable option for fast, emergency cash.
According to an insurance report from research organization LIMRA, nearly 60% of U.S. adult household decision makers are covered by some form of life insurance. These policyholders sought out coverage for help with burial expenses, replacing income, leaving an inheritance, and paying off debt after they pass. Life insurance is less commonly sought out for the benefits it provides to policyholders while they're still living. Specifically, permanent life policies build up cash that can be tapped in an emergency.
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Generally, debt is not the preferred way to cover emergency expenses. But if you don't have an emergency fund, you may have no choice. And when you look at the options -- using a credit card or borrowing from your 401(k) -- a life insurance loan may be the easiest to manage. Unfortunately, it's also the hardest debt option to understand. Here are five consequences you'll accept when you borrow from your life insurance policy.
1. Your cash value doesn't change
The funds for your life insurance loan don't actually come from your policy's cash value. Instead, the insurer lends you money directly and uses your cash value as collateral. This distinction is important, because it means cash remains in your policy and continues to earn investment income while that loan is outstanding. This is quite different from a 401(k) loan, which removes the funds from your retirement plan andreduces your investment performance going forward.
2. Your death benefit is reduced
As long as you have a loan outstanding against your policy, the death benefit is reduced by the loan amount plus any interest. Say your policy's death benefit is $150,000. If you borrow $10,000 and immediately die, your heirs will only get $140,000.
3. You incur interest, but payback is open-ended
As you'd expect, you will pay interest on your life insurance loan. The rate is set by the insurance company and could range from 4% to 8%. Often, the insurer will bill you for the interest annually on your premium renewal date. If you don't pay the interest charges, they'll be added to your loan balance where they'll accrue additional interest. That can snowball quickly, eating up your death benefit in the process.
What you might not expect is that the insurer won't establish a payback schedule for the principal. It's up to you how and when you repay those funds. Technically, the loan repayment is usually optional, but there are advantages to doing so. You'd restore the death benefit and end the accrual of interest charges.
4. You have to keep paying your premiums
Your policy may allow you to use accumulated cash value to pay your insurance premiums. That perk goes away when you borrow, since the cash is now earmarked as collateral for your loan.
5. You could incur taxes if you let the policy lapse
Life insurance loans are not taxable when the policy is active, but they could become taxable if the policy lapses for any reason. Basically, the Internal Revenue Service sees a taxable gain when the cash surrender value of your expired policy is more than the total premiums paid. Outstanding loan balances are problematic because the insurer will pay back your loan from your cash surrender value. That means you might end up with a tax bill and no money to pay it.
Here's a simplified example. Say you maintain your policy for 15 years and pay in a total of $15,000 in premiums. The cash value grows to $18,000 and you borrow all of it. If you stop paying the premiums and the insurance company cancels your policy, you won't get a payout because your cash value will be used to repay your loan. You will, however, owe taxes on the $3,000 difference between your cash value and your total premiums paid.
Stay current on interest and premiums
Sidestep the worst consequences of a life insurance loan by staying current on the interest charges and your annual premiums. Also, add a line item in your budget for emergency fund savings. When bad stuff happens, a cash fund offers much greater flexibility and less downside than any type of debt.
FAQs
If a policyholder takes cash out of a life insurance policy through a loan and pays it back entirely, their beneficiaries will receive the full death benefit upon the policyholder's death. If they die while there is a balance owed, that amount (plus interest) is subtracted from the death benefit paid to beneficiaries.
Is it a good idea to take a loan from your life insurance? ›
Borrowing against life insurance can be a good option for those looking for a loan with low-interest rates, flexible repayment terms and no credit check. However, it also comes with downsides like a reduced death benefit, risk of policy lapse and significant interest accumulation.
What is the cash value of a $10,000 life insurance policy? ›
A $10,000 term life insurance policy has no cash value. However, a permanent life insurance policy might. Usually, the cash value steadily accumulates over the years, but the cash value of some policies can decrease if an investment performs poorly.
What life insurance can you borrow from immediately? ›
Life insurance loans are only available on permanent life insurance policies — such as whole life and universal life — that have a cash value component. You likely can't borrow against a term life insurance policy since it probably doesn't have cash value.
How long does it take to get money borrowed from life insurance? ›
Loan funds typically arrive within one to 15 days. Let's say a person has been paying on their life insurance policy for 10 years and has built up $100,000 in cash value. That means their insurer may allow them to borrow between $90,000 and $95,000.
Is it smart to take money from life insurance? ›
It might not be wise to cash out a life insurance policy when you need money. You may want to consider how the decision will impact your family if you die without a policy or with a lower death payout due to this decision. Choosing an alternative way to access funds might make more sense for you now and in the future.
What could be the potential result of taking out a cash value loan under a life insurance policy? ›
Taking out a life insurance loan¹
If you die before you repay the loan the outstanding amount is subtracted from your death benefit. Regardless, until you pay the loan back, your debt is accruing interest, which can decrease your policy's potential death benefit.
What happens if you don't pay back a life insurance loan? ›
If you don't repay your loan before you die, it will be deducted from your beneficiary's death benefit. Risk of lapse. Even though you don't have to pay your loan back according to a set schedule, interest will continue to accrue, and the insurer will still make charges for policy expenses.
How long does it take for a whole life policy to build cash value? ›
A whole life insurance policy will begin building cash value as soon as you pay your first premium, and it will continue building throughout the life of the policy as long as there are funds in the account.
How much tax will I pay if I cash out my life insurance? ›
In general, a life insurance benefit isn't subject to taxes.
If you're considering how to use life insurance to build wealth, then you can start by looking for a policy with a cash value component. For cash value accounts, the insurer takes part of your insurance premium and puts it into an account intended to increase in value over time.
Which is better, term or whole life insurance? ›
Term life is more affordable but lasts only for a set period of time. On the other hand, whole life insurance tends to have higher premiums but never expires. Knowing the differences between term and whole life insurance will help you choose a policy that works best for you and your lifestyle.
Can you cash out life insurance before death? ›
If you have a permanent life insurance policy that has accumulated cash value, then yes, you can take cash out before your death.
Is money borrowed from life insurance taxable? ›
Is a Life Insurance Policy Loan Taxable? A life insurance loan is typically not taxed. However, if you surrender your policy or the policy lapses, you will have to pay taxes on gains made through investments and your outstanding loan will be deducted from your payout.
What is the cash value of a $100,000 life insurance policy? ›
Whole Life Insurance Cash Value Chart
| Whole Life (Fixed Death Benefit) Cash Value Accumulation for a $100,000 Policy |
|---|
| Policy Year | Age | Cash Value |
| 5 | 40 | $3,738 |
| 10 | 45 | $11,569 |
| 20 | 55 | $33,838 |
4 more rowsThe answer is yes: You can have multiple life insurance policies, and some people choose to keep more than one policy to provide additional financial security in the event of an unexpected death. Of course, there are both pros and cons to having more than one life insurance policy.
Do life insurance loans need to be paid back? ›
Yes, life insurance policy loans generally need to be paid back, though there is some flexibility in how repayment may occur. Policyholders are generally expected to repay the loan principal and interest during their lifetime. This allows the full death benefit to remain intact for beneficiaries.
How long does it take for whole life insurance to gain cash value? ›
How long does it take to build cash value on life insurance? The length of time varies by insurer, but in most cases, cash value does not start to accrue until you have paid premiums for two to five years.
Can I cash out my life insurance policy? ›
You can cash out a life insurance policy. How much money you get for it will depend on the amount of cash value held in it. If you have, say $10,000 of accumulated cash value, you would be entitled to withdraw up to all of that amount (less any surrender fees).
