The Pros and Cons of Borrowing Money From Your Life Insurance Policy
A life insurance policy is ideally something you take out with the intention of leaving your beneficiaries with a financial security blanket after your passing. But some types of insurance policies can provide an additional line of money you can borrow against, should you need to.
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“Borrowing from a life insurance policy refers to taking a loan against the cash value of a permanent life insurance policy, such as a whole life policy,” according to Eliezer Zupnick, insurance advisor and the founder of East Leads Group LLC, a commercial insurance firm.
“This cash value grows over time as you pay the premiums, and after a certain threshold, it can be used as collateral against a loan.”
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Pro: Quick Cash
“Borrowing from your life insurance policy, particularly a whole life or universal life policy with an accumulated cash value, can be beneficial in times of financial hardship due to its quick access and no qualification requirements — it’s your money, after all,” according to Griffith E. Harris Jr., certified insurance counselor and owner of Griffith E. Harris Insurance Services.
Because you’re borrowing from yourself, there’s no mandatory schedule for repayment.
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Pro: Tax-Deferred Growth
Borrowing from a life insurance policy isn’t merely a financial move; it’s a strategic play to access funds tactically, said Aleksey Krylov, CFO, financial analyst and managing director at FTERA Advisors.
“This maneuver allows individuals to tap into the tax-deferred growth within the policy’s cash value. By doing so, policyholders can access liquidity without triggering immediate tax liabilities, providing a tax-efficient source of funds for various financial needs,” he said.
“[R]epaying the loan and interest puts money back into your policy, accruing tax-free gains,” Zupnick added.
Pro: Emergency Funds
Additionally, if you haven’t been able to save enough for a buffer in your savings accounts, your life insurance policy may serve as a source of emergency funds, Zupnick said, especially when other options might not be available or favorable.
Pro: Flexibility With Caution
Borrowing from a life insurance policy allows individuals to swiftly respond to life’s demands, Krylov said, “whether it’s seizing investment opportunities, funding educational endeavors, or managing unforeseen medical expenses.”
“However, this financial agility demands a delicate balance with a cautious approach to avoid potential setbacks,” he warned.
Con: Reduced Death Benefits
One of those setbacks is not having as much money to leave to your heirs.
“For instance, any unpaid debt at the time of your death will reduce the death benefit to your beneficiaries, impacting the policy’s primary purpose,” Harris said.
Con: Lapsing Policies and Unintended Consequences
An often-overlooked risk to borrowing from life insurance is the potential lapse of the policy, according to Aleksey Krylov.
“In the complexity of managing loans, interest, and premiums, policyholders may inadvertently let their policies lapse. This unintended consequence can trigger tax liabilities and leave individuals without the intended life insurance coverage.”
Harris shared a cautionary case from his company’s portfolio: “A client used a life insurance loan to bridge a gap during a rough business patch. It seemed a sound choice, but the client neglected to monitor the policy. Over time, interest accumulated, and the loan risked policy lapse.”
Luckily, they intervened with a strategy to mitigate the situation, he said, “[b]ut it emphasized the perils of mismanagement — one must be vigilant when borrowing against life insurance to avoid unintended complications.”
Con: Interest Accumulation
If the loan is not repaid, the interest will keep accumulating, which can eventually lead to the policy lapsing, Zupnick said.
Con: Impact on Policy Performance
Additionally, if you’re taking out money, there’s less to sit and accumulate interest.
“Loans can impact the performance of the policy and potentially reduce the dividends,” Zupnick explained.
Considerations Before Borrowing
Before deciding to borrow from a life insurance policy, it’s important to consider the following, Zupnick suggested:
Policy Type: Only permanent life insurance policies, like whole life or universal life, have a cash value component that you can borrow against. Term life insurance policies do not build this cash value.
Cost-Benefit Analysis: It’s crucial to weigh the benefits against the costs, including the potential for reduced death benefits, policy lapse and the impact on policy performance.
Alternatives: Consider other alternatives for raising funds, such as a personal loan, home equity loan or even withdrawing from a retirement account, depending on your specific circumstances and the potential tax implications.
They call it insurance for a reason: It’s there if you need it, but you hope to not need it.
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This article originally appeared on GOBankingRates.com: The Pros and Cons of Borrowing Money From Your Life Insurance Policy
