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Life Insurance Loans
When people hear the word "life insurance" they immediately think "death benefit" and rightly so. Popular culture has all but forgotten about the benefits of cash value whole life insurance. So we decided to write an article that brings to light a forgotten benefit of life insurance that has helped people out in tough financial times years gone by.
Life Insurance Policy Loans
Some of my favorite stories to tell at cocktail parties (OK, I don't attend cocktail parties, but bear with me) have to do with famous people who use life insurance loans to fund their dream or protect their dream from dying.
Famous people such as Walt Disney who had to tap into his own insurance policy to help raise the necessary funds to open Disneyland.
Another is Ray Kroc who had to borrow from his cash value life insurance in order to keep afloat as he helped build what was to become one of the most successful franchises ever: McDonald's.
Two mainstays of American culture may never had been if it wasn't for the help of life insurance loans.
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Why Most People Get Life Insurance
Most people make the decision to buy life insurance because they want to provide their families with money just in case they were to pass away unexpectedly. For example, if a parent were to die with no insurance, the remaining spouse and children would be left without the deceased's spouses income or even no income at all if the second parent was staying at home to look after the children.
Now this is a very important concern and if you are the primary bread winner you should have life insurance. And most people in this position choose term life.
With term life insurance, the policy acts as "pure" death insurance. It is fairly basic in its setup, providing your chosen life insurance beneficiary with an income tax free death benefit should you pass away during the term.
With permanent life insurance, such as universal life and whole life insurance, this is very different from term because a percentage of your premium will go towards expenses and fees, while the rest of your premium goes into a separate interest bearing account. Over time, this account builds cash value and you can use this money however you see fit, including:
- If your finances get tight and you’re struggling to pay the bills, your policy's cash value can be used to pay premiums for a while.
- If you’re happy to reduce the death benefit, you could withdraw the cash and not repay it.
- You can also use the cash value as collateral as you borrow money tax free* from the life insurance company's general account.
*If the policy lapses with an outstanding loan it could trigger a taxable event. More on potential tax ramifications below.
Before we go through the advantages of using your cash value as collateral so you can take out a life insurance policy loan from the carrier, let's first discuss how exactly it works.
Generally speaking, you’ll be allowed to borrow any figure as long as it’s under the cash surrender value of the policy, typically around 90% of the policy's cash value.
Although you will be charged interest along the way, this interest is actually added onto the policy loan rather than paying it outright. So the longer the loan is outstanding, the larger the outstanding balance becomes. This is lessened by your policy's gain in interest and potential dividends for whole life or your index crediting for an IUL.
Some participating whole life policies (i.e. the ones that pay dividends) and some indexed universal life insurance policies will have positive arbitrage between what your loan rate from the company is and what your policy is growing at.
For example, if your whole life policy has a guarantee of 4% interest, plus another 2-2.5% thanks to the dividend, your total dividend rate would be 6-6.5. So if the the company charges 5% for a policy loan, you stand to make 1-1.5% positive arbitrage on the cash value policy loan.
Now, you may even be able to increase the benefit of taking out that positive arbitrage loan by investing the borrowed money from your cash value into an investment vehicle that yields a rate of return. Say you borrow from your policy and purchase a rental property that is giving you positive cash flow passive income.
So you take the original 1-1.5% positive arbitrage and invest it in an income producing property yielding a return of say 6% or more, not including deductions and depreciation. Add 6 and 1 and your return is 7%. And as you begin to pay down your loan, (perhaps with the cash flow from your new rental property), you are actually increasing your rate of return on your money because paying down your principal in your loan is causing less interest to accrue.
Now we might have just went too fast there so let's back up and get back to some basics about life insurance loans.
Life Insurance Loans Pros and Cons
So we mentioned a potential big pro above with positive arbitrage. Let's consider some other benefits of borrowing from your cash value.
No Credit Check
As long as you have a policy with the insurance company that has sufficient cash value to borrow against, you won’t have to undergo a credit check and all the other hassles that normally come with taking out a loan. If you were to apply for a loan from a bank, you’d be required to undergo an extensive application process with no guarantees you'd actually be offered the money at the end of it all.
No so with life insurance loans. If you have cash value in your policy, this is all the carrier requires to guarantee your loan. You have contractual rights in your policy to be able to take out a policy loan against available cash value with no questions asked.
Does Not Show Up On Credit Report
And note that life insurance loans will not show up on your credit report, which is another huge plus. if you’re applying for a mortgage or car elsewhere, your policy loan won’t have an impact on your credit report. So you can take loans from life insurance to make a down payment on your real estate investment and it won't impact your financing because it won't show up when the lender runs your credit.
No Strict Payback Schedule
With a bank loan, you’ll be cornered into a strict timetable for repayments and trouble is afoot as soon as you miss a payment; this has a negative impact on your credit score and could affect your finances for a number of years.
With loans on life insurance, you can repay whenever you have the spare money available. As we said before, you don’t even have to repay anything at all if you’re happy enough to see your death benefit reduce or if the policy is efficient enough to gain interest and dividends to offset the loan balance interest.
Low Interest Rates
Compared to bank loans and even credit cards, the interest you pay on a life insurance loan will be respectable. For credit cards, the average interest rate currently is pushing 14% while a two-year personal loan is a little over 10%.
Compared to a hard money loan, the rate on loans from life insurance companies is minimal. The current interest rate will vary from company to company and can change depending on different factors, such as how long you have had your policy with the carrier. Right now, you can expect to pay a rate between 4-8%. We tend to favor the companies that have lower policy loan rates, particularly for clients who know they will be utilizing policy loans.
Unlike the 529 Plan which can actually disqualify your child's eligibility for a FAFSA loan, life insurance cash value is not taken into account when your child is applying for a student loan. So if you were one of those forward thinking parents who set up life insurance for their kids, they can take out a policy loan to pay for whatever they need, while simultaneously qualifying for the FAFSA student loan program.
And another thing you should be aware of regarding the topic of life insurance student loans is that student loans are forgivable upon death. But here is the kicker, the forgiven loan is taxed as income against your estate. A big reason getting life insurance to cover student loan debts is a good idea.
Drawbacks of Life Insurance Policy Loans
Despite all the positives, there are also some negatives to life insurance loans. Once you know both sides of the story, you can decide whether a cash value policy loan is the right choice for you in your particular situation.
You Have to Grow Your Cash Value
In order to take loans on life insurance policies there must be cash value in the policy. So you first need to build up the cash value of your policy. The key to high cash value growth is to build a policy focused on cash value, rather than a death benefit. This can be achieved with certain indexed universal life policies and with whole life insurance using paid up additions along with with some other riders that help build cash in your policy fast.
Risk of Lapsing Your Policy
If you have an outstanding life insurance loan and you don't make a payment when it is due, the interest will be added to your existing principle balance. Your principle balance, plus accrued interest bear interest at the payable loan rate. If you have had the policy for a short time your policy will not be that efficient and a large unpaid policy loan can destroy your policy.
You policy loan and any accrued but unpaid interest go against the death benefit. That means your death benefit will gradually reduce if you choose not to repay the loan, or if you do not pay the full amount due, which may leave your family under-protected. If you die prematurely and don't have the full death benefit available for your loved ones it can have devastating effects, as your family may not have enough money to replace your income, pay down debt or meet other financial needs.
Some policies, such as properly designed participating whole life insurance, can be a lot more forgiving than other universal life policies, such as Variable Universal Life. It always pays to be vigilant and seek out help when necessary in order to stay on top of your existing loan balance and interest.
Policy Loan Interest Not Tax Deductible
Unfortunately, unlike mortgage loan interest, you cannot add interest expense from your policy loan to your tax deductibles. However, you may want to consult with a tax professional and find out if there is a potential deduction for your business if you loan money from your cash value policy to your business and in return, your business pays you interest on the loan.
Potential Adverse Tax Consequences
In the case of your policy terminating before you die, you could get hit with a large income tax liability. If your policy terminates you will have to add to your taxable income outstanding loan amount excess and any cash given to you above your cost basis in your policy. Alternatively, you may need to make large premium payments to get caught up on your policy and keep it in force.
Another potential pitfall to avoid would be in the case of your policy being considered a modified endowment contract or MEC. A MEC is a cash value policy that fails the 7 Pay Test. If your policy is considered a MEC then life insurance loans are taxable as ordinary income on any gains in the policy. Another issue to keep an eye on with a MEC is that it is similar to other non-qualified plans, if you take out a loan before age 59 1/2 any taxable gain may additionally incur a 10% penalty.
With some companies, they add their own rules to a policy loan and you’ll need to pay attention to the small print before you get started. For example, some will not pay dividends or will adjust the payment of dividends while the loan is in effect.
Direct vs Non-Direct Recognition
For certain purposes it may be important to know the difference between non-direct and direct recognition whole life insurance companies. These represent two different ways that carriers recognize (or don't recognize) outstanding loans on life insurance policies.
Non-Direct Recognition: Non-direct recognition simply means the company does not recognize an outstanding policy loan when determining interest and dividend paid on your policy's cash value. The benefit is your entire cash value is taken into account when determining your total policy life insurance dividend.
Direct Recognition: Direct recognition means the dividend paid to participating policyholders that have an outstanding loan on life insurance is adjusted or lowered.
Should You Take Out a Life Insurance Loan?
After assessing all this information, it leaves just one main question; should you take a life insurance loan against your cash value? If your financial position allows, and ONLY if your financial position allows, a life insurance loan can be a great way to avoid huge credit card bills and extortionate interest rates.
However, they won’t be perfect for everyone and that’s why you need to keep your own position in mind. Your needs and circumstances should always be the most important consideration. If you need to seek out the advice of a finance professional to help assess your position, so be it; they may just provide an alternative you didn’t know existed.
Ideas for Using Life Insurance Loans
One of the great things about permanent life insurance designed for cash value growth is that you have a safe bucket of assets waiting in case of an emergency or opportunity.
We mentioned a couple stories at the outset about how people have used their policy's cash value as collateral for a loan from life insurance to help fund their dream business. They saw the opportunity and we able to capitalize on it because they had the needed resources at their disposal.
It is no secret that many Americans are stressing about their retirement because they have very little to live on apart from social security. Cash value life insurance works as a forced savings vehicle to help provide supplemental retirement income. You can work out a plan with your trusted advisor that allows you to take out a life insurance loan and use that money to help fund your retirement. And you will never have to pay it back, not will it deplete your policy's cash value, if you plan properly.
Another way you can utilize life insurance loans is by taking loans to pay for large ticket items. Rather than borrow from a bank, you can act as the banker, using your policy as the bank. You then set up your own repayment schedule and pay yourself back, rather than a bank.
One last thing we will mention is using loans on life insurance to purchase investment opportunities. We mentioned real estate above, but what about dividend paying stocks, coffee farms, oil wells, timber, etc... there are always investment opportunities. The key with cash value life insurance is you will have a safe bucket of assets ready to take advantage of these investment opportunities when they appear.
Cash value life insurance is not for everyone. And using policy loans is certainly not for everyone. I'd say it is only for those who are disciplined and know how to manage their finances. Taking out a loan can have negative repercussions so make sure you are ready to commit to managing your policy and your loan. If you are, life insurance loans can be a great way to help fund your journey to financial freedom.