Borrowing against an insurance policy

A benefit of purchasing permanent life insurance is the ability to take out a loan against the policy in the event of a financial emergency. Whole life and universal life insurance are types of permanent life insurance plans that accumulate cash value as the policy owner pays premiums, and the owner can borrow against that cash value. If you decide to take a loan out against your permanent life insurance policy, there are a few things to keep in mind.

First, let’s discuss the difference between permanent life insurance and term life insurance. Permanent life insurance plans combine a death benefit and a savings portion. The premium paid goes toward paying for the insurance and toward the savings portion. Permanent life insurance plans can build cash value and do not expire.

Term life insurance plans cover the policy owner for a set time period and do not build cash value, because the entire premium paid goes toward the cost of the insurance. The policy expires after the term is up, though there are generally options to extend the policy.

Taking out a loan against a permanent life insurance policy offers distinct flexibility when you need to access capital. Because you are borrowing against the policy’s accumulated value, the funds can be used for any purpose, from funding a child’s college education to covering major travel expenses.

The Key Benefits of Policy Loans

• Streamlined Access: Because your accumulated cash value acts as collateral, you do not have to go through a traditional bank approval process, and there is no credit check.

• Repayment Flexibility: You have multiple options for handling the loan over time, including making principal and interest payments, choosing interest-only payments, or using the remaining cash value to cover periodic interest charges.

• No Rigid Deadlines: There is no fixed timetable to repay the loan. While completely walking away from repayment is not always advisable, you are not legally required to pay it back during your lifetime.

• Competitive Cost: Because the loan is secured by your own policy assets, the interest rates charged by carriers are generally lower than traditional bank loans or credit cards.

While borrowing against an insurance policy is a highly useful financial tool, the SEC and IRS require a clear understanding of the operational risks involved:

• Tax Considerations: Under current IRS rules, policy loans are generally not recognized as taxable income, allowing you to access liquidity tax-free. However, this status is conditional upon the policy remaining in force. If the policy lapses, is surrendered, or is classified as a Modified Endowment Contract (MEC), any outstanding loan balances may be treated as a taxable distribution to the extent of the policy’s internal gains.

• Early-Year Limitations: The cash value of a permanent policy builds gradually over time. Consequently, there may not be sufficient cash value available to borrow against during the initial years of the plan.

• Impact on the Death Benefit: While there is no strict repayment schedule, interest on the loan will continue to accrue on the outstanding balance. If the policy owner passes away before the loan is fully repaid, the final death benefit paid to beneficiaries will be reduced by the total outstanding loan amount.

• Lapse Risks: Accruing interest can put the entire policy in jeopardy of structurally lapsing if the total loan balance grows to exceed the policy’s remaining cash value. To keep the loan balance from growing compounding out of control, it is generally advisable to at least pay the periodic interest.

A permanent life insurance policy can prove to be an excellent tool if you need an efficient way to secure liquidity, but it is critical to carefully weigh the long-term impact the loan will have on the policy’s compounding health and your beneficiaries’ final protection.

Our financial advisors at Insight Wealth Strategies will meet with you to evaluate your specific wealth management situation and help determine the most efficient course of action. Please contact us at (925) 659-8020 with your specific questions or to schedule a consultation at our San Ramon, CA or Houston, TX offices.