Casey Bond is a seasoned personal finance writer and editor. In addition to Forbes, her work has appeared on HuffPost, Business Insider, Yahoo! Finance, MSN, The Motley Fool, U.S. News & World Report, TheStreet and more. Casey is also a Certified.
Casey Bond ContributorCasey Bond is a seasoned personal finance writer and editor. In addition to Forbes, her work has appeared on HuffPost, Business Insider, Yahoo! Finance, MSN, The Motley Fool, U.S. News & World Report, TheStreet and more. Casey is also a Certified.
Written By Casey Bond ContributorCasey Bond is a seasoned personal finance writer and editor. In addition to Forbes, her work has appeared on HuffPost, Business Insider, Yahoo! Finance, MSN, The Motley Fool, U.S. News & World Report, TheStreet and more. Casey is also a Certified.
Casey Bond ContributorCasey Bond is a seasoned personal finance writer and editor. In addition to Forbes, her work has appeared on HuffPost, Business Insider, Yahoo! Finance, MSN, The Motley Fool, U.S. News & World Report, TheStreet and more. Casey is also a Certified.
Contributor Ashlee Valentine Deputy Editor, InsuranceAshlee is an insurance editor, journalist and business professional with an MBA and more than 17 years of hands-on experience in both business and personal finance. She is passionate about empowering others to protect life's most important assets. Wh.
Ashlee Valentine Deputy Editor, InsuranceAshlee is an insurance editor, journalist and business professional with an MBA and more than 17 years of hands-on experience in both business and personal finance. She is passionate about empowering others to protect life's most important assets. Wh.
Ashlee Valentine Deputy Editor, InsuranceAshlee is an insurance editor, journalist and business professional with an MBA and more than 17 years of hands-on experience in both business and personal finance. She is passionate about empowering others to protect life's most important assets. Wh.
Ashlee Valentine Deputy Editor, InsuranceAshlee is an insurance editor, journalist and business professional with an MBA and more than 17 years of hands-on experience in both business and personal finance. She is passionate about empowering others to protect life's most important assets. Wh.
| Deputy Editor, Insurance
Updated: Jul 9, 2024, 6:51am
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There are advantages to life insurance beyond the death benefit. If you have a policy with a cash value component, you can borrow money from your life insurance. Cash value life insurance can be one of the most convenient, low-cost financing options out there. But there are also pitfalls to avoid if you take out a life insurance loan.
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A life insurance policy loan is a loan you can take out against the cash value component of a cash value life insurance policy. Life insurance loans are not the same as other loans: Policy owners are not required to repay the loan. But, the insurance company will charge interest on the policy loan.
Policy loans come in the form of direct loans or indirect automatic premium loans, according to Barry D. Flagg, Forbes Advisor advisory board member.
With a direct loan, you essentially borrow money from yourself, with the policy’s cash value serving as collateral. For this reason, you don’t have to pay income tax on the money you take out. The insurance company will charge interest (called a spread).
Flagg explains that you essentially pay the interest back to yourself, less a spread charged by the insurance company. Usually, this can be as little as 0.25% (even 0% in some cases) or as much as 2%.
“Choosing a policy with a low loan spread can make a big difference,” Flagg says. “Either way, policy loans reduce both the policy account value and the death benefit by the amount of the loan on a dollar-for-dollar basis.”
If you pay the policy loan before you pass away, there is no deduction from the death benefit.
An automatic premium loan (APL) allows the insurer to use your cash value to pay your life insurance premiums if you don’t.
“While insurers generally send notice of such automatic premium loans, consumers don’t often understand the implications,” Flagg says. “So this type of policy loan can unwittingly accumulate for years.”
Flagg says that interest is also added to the balance, often at unfavorable rates. So when policyholders aren’t aware of these implications, APLs can grow quite large, eroding the cash value and causing a policy lapse.
Most permanent life insurance policies offer the opportunity to borrow money from the cash value.
Permanent life insurance (including whole life, universal life and variable life) is designed to provide coverage for your lifetime.
Permanent life policies build cash value as you pay the premiums. The cash value portion of the policy either earns interest or is tied to an investment account or index, allowing you to grow the money over time.
Term life insurance, by comparison, is not life insurance you can borrow from. Term life insurance is a fairly low-cost option designed to protect people when they need it most, such as the working years until their mortgage is paid off. These policies do not have a cash value component.
Loans are available on life insurance policies when there is enough cash value. The amount you can borrow is represented as a percentage of the cash value. Each life insurance company has rules about how much policyholders can borrow, but Flagg says it’s usually around 90% to 95%.
Using those percentages, if your policy cash value is $50,000, you may be able to borrow $45,000 to $47,500.
Since the insurance company will not require you to pay back the loan balance, they will not provide a repayment schedule. You have the option each year to pay loan interest out of pocket or borrow the interest. If you choose to borrow the interest, the loan balance will compound, which means the interest due each year will compound.
It’s important to request an in-force policy illustration annually to determine the impact of a policy loan. Your request should include the following scenarios, along with any others that reflect your plans:
Median time for no-exam application approval
Maximum no-exam coverage amount
Term lengths available
10, 15, 20, 30 years
On Ethos Life's Website10, 15, 20, 30 years
Policy loans can be repaid in one of three ways.
Ideally, you would repay your loan with cash payments to the life insurance company. “Repaying in cash increases both the policy account value and the death benefit by the amount of the repayment on a dollar-for-dollar basis,” Flagg says.
Flagg says that if costs being charged in a policy can be reduced, and the cash value is then more than enough to cover reduced costs, a policy loan can be repaid with “excess” cash value. He warns, however, that if the loan repayment amount is greater than the amount of the policy cost/tax basis, then repaying this way can trigger a taxable event.
If your policy loan balance is still outstanding when you die, the loan balance will be deducted from the death benefit. Your beneficiaries will receive a reduced benefit. Even so, Flagg says that because death benefits are received tax-free, repaying policy loans this way is the most tax-efficient means of repayment (versus repaying with cash that has already been taxed or a withdrawal of excess cash value that could be taxed).
If you’ve taken out a loan from the cash value, the lower cash value will result in lower earnings. If your premium payments aren’t enough to cover the mortality cost and other fees, the insurer will take it from your cash value. Your cash value is being depleted by multiple demands—the loan, lower earnings and fees. If the cash value goes to zero, the policy will terminate unless you make additional premium payments.
If the policy terminates, you’ll get dinged by an income tax bill on the loan money you took.
Here’s how to calculate the potential gain in the policy that would be subject to income tax:
Example: If a life insurance policy terminates with a loan balance of $100,000 and a cost basis of $50,000, the taxable gain would be $50,000.
Please note that the above example is a general rule and may not apply to every situation. You should consult your tax advisor to confirm whether you have a taxable gain.
Your life insurance company will be able to provide you with the cost basis and the gain, which they will report to the Internal Revenue Service as 1099 income.
While a life insurance policy loan can provide you with immediate funds, it can have a number of drawbacks. Know what you’re getting into before you take the cash.
Consider these pros and cons before borrowing money from your life insurance policy.
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ContributorCasey Bond is a seasoned personal finance writer and editor. In addition to Forbes, her work has appeared on HuffPost, Business Insider, Yahoo! Finance, MSN, The Motley Fool, U.S. News & World Report, TheStreet and more. Casey is also a Certified Personal Finance Counselor. Follow her on Twitter @CaseyLynnBond.
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