“A bank is a place that will lend you money if you can prove that you don’t need it.”Bob Hope
Months ago, we asked the question, “Should you borrow against your life insurance policy or withdraw from it?” Today, we continue the topic of borrowing against life insurance by looking at the advantages and disadvantages of doing so.
The Advantages of Borrowing Against Life Insurance
A life insurance loan can be a great way to access your cash while still earning interest and dividends on your full savings. However, because you’re taking a loan against your policy, many people write off this strategy. Here are some of the advantages we think make it worthwhile to borrow against your policy with a life insurance loan.
1. It’s Simple and Quick
There’s NO QUALIFICATION process, no need to fill out an application, have your income or credit checked, nor brace yourself for high fees and taxes (in most situations, see below exceptions). You’ll have your loan in 5-10 business days for most companies, and occasionally they have faster options. This means that if you’re in a pinch and you need cash for whatever reason, you can get it. The bank, on the other hand, may make you jump through hoops and fill out paperwork and still decline your application.
2. It’s Flexible
You can borrow about 95% of the cash value amount of your whole life policy from most mutual insurance companies. And when you borrow against your insurance policy, you can design your own repayment schedule, modify it as needed, or even continue down the path of life without repaying it if your circumstances require. In contrast, most types of non-insurance loans have strict repayment schedules that may or may not work well for you. Especially if what you want is just a little bit of breathing room in your finances.
3. It’s Cheaper Than You Think
Life insurance loans are running in the 4–8% range right now. Yet that does not equate to a bank loan for the same amount. This is because you’re borrowing against life insurance that likely has an internal rate of return of 4-5%, depending on your age and how long you’ve had the policy. And since you are borrowing against your cash value, not withdrawing the cash value, your account continues to grow and earn dividends, which offsets the interest on the policy loan.
4. It’s (Probably) Not a Taxable Event
Although there are exceptions, typically the IRS will never know that you borrowed the money. Like taking a second mortgage or line of credit against a rental property, a policy loan is not considered “income” in most situations.
What Happens to the Interest You Pay on a Life Insurance Loan?
There is a misunderstanding about borrowing against your life insurance. Sometimes people say that you’re “paying yourself interest,” which is not exactly accurate. You’ve neither borrowed from yourself nor are you paying yourself interest. What’s really happening is you’ve borrowed from the insurance company, using your cash value as collateral. The interest is likewise being repaid to your insurance company.
However, in a roundabout way, the interest benefits all policyholders because, with a mutually owned insurance company, they pay policyholders dividends (which represent profits). In a nutshell, interest on loans made to policyholders turns into profit for the company, which translates to future dividends for you, the policyholder.
As the Truth Concepts blog states in a post entitled, “Life Insurance Loans: Where does the interest go?“
“This is a good deal for everyone because the insurance company earns money, the owner of the policy gets use of the money while their cash value keeps growing, and all the other policyholders know the insurance company is investing their money properly, since the interest charged is reflective of the rates in the marketplace.”
The Disadvantages of Borrowing Against Life Insurance
1. Fewer Assets for Yourself
One disadvantage you may always have when borrowing money from a life insurance policy (or a property) is that you’ll have fewer assets to use or borrow against (unless you are leveraging your asset to acquire a greater asset), plus of course interest to pay. So you always want to evaluate whether the loan is necessary or not, or whether you can simply reduce your spending and avoid taking the loan in the first place.
Always take the time to talk with your advisor or agent to understand the impact that borrowing against your life insurance will have! Don’t assume that just because you have “permanent life insurance” that you can or should borrow against it. Some forms, such as Universal Life and Equity Indexed Universal Life (EIUL) operate very differently from whole life insurance.
2. Fewer Assets for Heirs
Although you don’t “have to” replay loans against your cash value, unpaid life insurance loans (and their interest) reduce total benefits to beneficiaries. One solution to this quandary is to fund some Paid-Up Additions, or PUAs, as you repay the loan. With a PUA, approximately 95% of the money goes to cash value, and about 5% or so goes to incrementally increase the death benefit. PUAs raise the cash value amount available to you for future years, while also raising the death benefit for heirs.
3. Potential Taxes
Outstanding loan balances may trigger a “tax event” (typically the issuance of an IRS Form 1099) if you borrow more than you’ve saved (because of growth) and choose to cancel or surrender your policy at a later date. Certain types of “cash-rich” insurance policies have been designated “modified endowment contracts” (or MECs) by the IRS. Loans against MECs are not tax-free. If you suspect that your contract might be a MEC, be sure to ask about the loan’s possible tax consequences before you borrow. (A properly structured whole life policy will not be an MEC.)
4. Cash Value is Your Policy’s “Emergency Fund”
If you’ve borrowed a high percentage of the policy’s cash value and do not pay premiums on time, your policy may lapse, resulting in the loss of coverage (the “death benefit” paid to the beneficiary) and possibly triggering a further tax event. Since cash value is like the equity of your death benefit, and because cash value acts as the collateral for your loan, having a policy implode like this can mean you’re left with very little in the end. You’ve got to have the discipline (and cash flow) to save into your policy and pay your loans.
Is There a Better Option Than Borrowing Against Life Insurance?
That depends on the situation. Sometimes, there could be better options than life insurance loans that have even lower costs. For instance, it’s hard to beat a tax-deductible Home Equity Line of Credit (HELOC) at rates of as little as 3% APR.
Of course, there are fees and interest involved in borrowing money against a property, and now many lenders are charging substantial prepayment fees for short-term borrowers. Since the real estate market crash, it has also become much more challenging to qualify for those loans. Both the borrower and the property must fit lending requirements, such as sufficient equity, a steady job with income several times any debt payments, and good credit.
Borrowing from or taking money from retirement accounts can generate fees and taxes, and because of employer plan restrictions, some investors find themselves unable to borrow against their 401k, even in emergencies. When they can borrow, they will be typically limited to $50k or 50% of the vested funds, whichever is less. And unless the reason is a down payment on a home, the funds must be paid back within 5 years. Another major issue is that you’ll have to replace the borrowed funds with after-tax dollars—which will then be taxed AGAIN at withdrawal! (unless it is a Roth)
The rules for IRAs are even stricter. They are typically not accepted as collateral and you can only access your funds for a 60-day period in what is considered a “tax-free rollover,” and that time frame is firm. Beyond the 60 days, you’ll pay income taxes, and a penalty, plus lose the ability to put the money back in your IRA.
Should YOU Borrow Against—Or Begin—A Whole Life Insurance Policy?
There’s no better time to start a whole life insurance policy than today, while you’re thinking about it. Besides the benefits of a life insurance loan, there are also many advantages to having insurance. You can protect your income and assets, which helps you live life more freely knowing you’re protected. Plus, it takes some time to build up cash value. If you think you may want to use a policy for life insurance loans someday, it’s a good idea to get started with your saving now.
We can help you through the process of getting whole life insurance, and we can tailor it to your specific desired and financial objectives. If you’re ready, let’s get started.
At Prosperity Thinkers we use Truth Concepts™ financial software to compare different financial strategies. We show you how to create better money methods, and save money with certainty, apart from market risks and instabilities. We can help you consider opportunity costs, taxation, risk and returns, and more. Contact us to find out more.