Need a chunk of change? Perhaps it’s an emergency, perhaps it’s a business opportunity, or it may simply be a periodic major purchase such as a new car. Either way, it’s bound to happen. You’ve got a need for cash, and you have to decide whether to get the cash from a credit card, a retirement account, a home equity line of credit, or somewhere else.
Would it surprise you to know that if you’ve been paying whole life insurance premiums, you’ve been saving just for this situation? Your premiums don’t just contribute to a death benefit after all. You also get benefits, such as your cash value, to use while you’re living. This is just one of the reasons that whole life is such an efficient financial product.
So how do you use the money you’ve accumulated in your policy? Should you take a policy loan or simply withdraw the money from your cash value? (Many people talk about “borrowing” their cash value but that is incorrect. You can either withdraw it, or borrow against your cash value.)
Withdrawing Cash Value is Simple
You simply take it out and go! Yet there is a long-term impact to withdrawing your cash. Withdrawal means liquidation, which means you lose that part of your asset. You cannot put money back into your policy, so ultimately you have less cash value left to earn dividends, grow for the future, or borrow against. It’s important to consider the opportunity cost of this decision. However, for many people, there’s an advantage to having no interest charges or penalties. (Though you may pay some income taxes, depending on how much you take.)
Borrowing Against Cash Value is ALSO Simple
When you borrow against your policy, you take a loan from the life insurance company with your cash value as collateral. When you do this, you usually have your money within a week. There are no qualifications required (other than sufficient cash value). Most companies will loan policy owners up to 90% or more of their cash value balance, while the cash value still earns dividends. However, you must pay interest on the loan, which currently varies between 5-9%, depending on the mutual company.
In this post, we’ll give you our rules of thumb to help you decide which is right for you—a cash value withdrawal, or a whole life policy loan.
Advantages to Using a Policy Loan
Some “pros” to using a policy loan are:
- While you pay back your policy loan, the underlying cash value you are collateralizing keeps growing. Your cash value continues to earn dividends, which offsets the interest you pay.
- There are no qualifications required for your loan, other than having the cash value to borrow against.
- You can pay back the loan on your own schedule, fast or slow, steadily, or in a lump sum.
- You pay interest in advance on an annual basis. Yet if the loan is paid back early, you will receive a refund for the “overpaid” interest.
- Loans are tax free (as long as your policy remains in force, and your repay your loans eventually).
- Whole life policy loans do not affect your credit and are not tracked by the IRS, credit reporting agencies, banks, or anyone other than you and your insurance company.
- Should you find yourself unable to pay the loan, you could still pay for it with your cash value, liquidating that part of the asset, but erasing the loan.
What Are the Disadvantages?
The main disadvantage to policy loans are, obviously, the interest. Interest rates currently being charged for whole life policy loans are between 5 and 9%. And contrary to common urban legends, you do NOT pay the interest “to yourself.” At least, you’re not doing so directly. Instead, the interest you pay goes to the insurance company (who services your loan). The interest you and all policy owners pay to the insurance company benefits the company. And as a policy owner, it benefits you, since they pay profits to policy owners. (A whole life company is a mutual insurance company and is structured more like a cooperative than a corporation with stockholders.)
The main advantage of withdrawals is simple—you don’t have to pay it back! It’s your money, and you are free to take it without penalty or taxes (yet only up to your basis).
Cautions About Policy Loans and Withdrawals
Some reasons you might not want to borrow against your policy (if you can help it) include:
- Withdrawals are treated as taxable income if you take more out than what you put in to the policy. If you withdraw repeatedly, you risk creating taxable events.
- Withdrawals reduce your current and future dividends, because it reduces your cash value. Your dividends are based on your cash value amount.
- When you withdraw money, you cannot “put it back.” That is simply the rule of insurance. You can pay NEW premium, and earn NEW cash value. However, you cannot “put back” withdrawn money into your cash value.
- Policy loans, as well as withdrawals, reduce your death benefit. (This is not a terrible thing in most cases, as a properly set up policy will have an escalating death benefit over time.)
- Interest continues to accrue on unpaid policy loans. If you have no plan to repay, and you expect to live decades longer, withdrawing is a better option.
Managing Your Whole Life Policy for Maximum Benefit
The financial mainstream trains consumers to avoid debt and “pay with cash.” So it might seem like a no-brainer to simply withdraw your funds rather than take a loan. Yet if you look at your whole financial picture and consider the potential future costs of this decision, you may see things differently.
Some Questions to Consider:
Do you have the means to pay a policy loan back?
If you have steady income, or even a history of steady income, policy loans make perfect sense. Perhaps you work on contract and are just in between contracts. Or perhaps your income is not the issue, you just simply had a large expense or purchase. Even if it may take months, even years to pay it back, if you believe you can pay it back, the loan is the way to go. That way, your cash value can continue to benefit from uninterrupted compounding growth. This is a perk that a regular savings account cannot typically be used for.
You may also be interested to know that as the policy owner, you have a significant amount of control over your loan. While you cannot dictate the interest rate, you can control your repayment schedule completely, making it more flexible than a credit card or bank loan. So if you have the means to repay, a loan is a great option.
If you cannot conceive of paying back your loan because of a continuing lack of income, (perhaps you are no longer working), a withdrawal is almost always the best choice.
How old are you? What are your circumstances?
If you are 90 years old, and no one is depending on your death benefit, you can still take a policy loan. You can have this peace of mind because your death benefit will cover your outstanding balance.
However, if you are in your 70s or even in your spry 80s with limited income, you may be better off withdrawing rather than borrowing against your cash value. After all, a loan will continue to accrue interest. This can spiral if not paid. And if you live for 10, 20, or even 30 more years without paying loans, your policy could implode.
If you are younger, withdrawing is going to have a greater negative impact on your savings. As a general rule, we advise someone who is active and has sufficient income to pay off a policy loan to borrow against their whole life cash value rather than withdraw. However, if you feel you have limited prospects for future income sufficient to repay the loan (and don’t want your life insurance to lapse), withdrawal is the better option.
Is your need for money temporary?
If you need the money for a limited time only, a policy loan probably makes the most sense. You don’t want to compromise your long-term savings because of a temporary need, if possible. (Yet again, consider your age and circumstances.)
Are you using the money to create more money?
Our own Kim D. H. Butler was interviewed on the popular Real Estate Guys about how whole life insurance makes a great companion to real estate investing, because it’s an ideal vehicle to provide short-term cash for investments. With real estate investing (and many other businesses), you can have short-term cash flow needs, and be able to use that money to generate a return, which allows you to pay off what you have borrowed.
We even have clients that borrow against their cash value to make short-term, fixed-rate loans secured against real estate or other assets that can bring them returns MUCH higher than their cost of obtaining the money through the policy loan. (This should only be done very cautiously, but can be a powerful wealth-building strategy when carefully considered.)
Have you measured and considered your opportunity costs?
When making a major purchase, such as a new roof or a new car, many policy owners actually strategize intentionally to borrow against their life insurance cash value. In this way, they minimize the opportunity cost of paying cash.
We are trained to measure interest paid on debts, yet learn very little about opportunity cost. This concept helps you identify interest not earned when you save in a bank and pay cash, rather than storing that money where it can grow. Opportunity cost is every bit as important to measure as the interest you’re paying (if not more so). We either “pay up or pass up” interest, and it is critical to have MORE MONEY working for you than less money, even if it creates temporary debts in the process.
Learn more about Opportunity Cost in our post about the real cost of financial decisions.
To Borrow Against or Withdraw: Which is the Best Option for You?
It is essential to consult with a life insurance specialist before purchasing your cash value life insurance policy and they can help you construct your policy to meet your goals and objectives when it comes to taxes, death benefit payouts, income, even how you may wish to use policy loans.
If we can help you set up a life insurance policy, consider your available options, or answer any questions you have about insurance, we’d love to hear from you. You can connect with us here, or email firstname.lastname@example.org.