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Your cash value life insurance policy can be a valuable source of funds to draw from if you have unexpected expenses or during retirement or later in life.
If you’re trying to decide whether or not to borrow from life insurance in order to cover an unexpected (or expected) expense, such as a medical bill or long-term care services, there are several things to consider.
Borrowing from life insurance can be an ideal one depending upon your circumstances, but this alternative does come with some drawbacks.
If you apply for a loan from a bank, you have to fill out a lot of paperwork and, assuming that the bank likes what it sees on the forms, the bank will then run a full credit check on you to see what rates and terms you qualify for.
But a loan from your permanent life insurance policy is different: there is no underwriting process, and in many cases, you don’t even have to fill out any forms. You can just call the life insurance company, find out how much you can borrow from your policy and then have them send you a check or pay you via direct deposit.
This article will cover the basic information you need to decide if borrowing from your life insurance is the right move. We’ll also discuss alternatives that could be better options when you need money later in life.
What is a Life Insurance Loan?
Simply put, a life insurance loan is a loan that you take out using the accumulated cash value in your life policy as collateral.
A life insurance loan is only available in cash value policies such as whole life insurance, universal life insurance or variable universal life insurance. It is not possible to take out a loan against a term policy because it only offers pure death benefit protection and does not have any cash value.
Life insurance loans generally allow you to withdraw more than you can get if you make a direct withdrawal from your policy’s cash value because there are no costs and fees deducted.
However, as with any other type of loan, a loan against your cash value will charge you interest that comes out of your remaining cash value. For example, if you have $5,000 of cash value in a universal life insurance policy, you might be able to make a maximum direct withdrawal of $4,500, with the other $500 either remaining in the policy or being used to pay for administrative expenses.
But you could instead take out a life insurance loan for the entire $5,000, and the interest charged on the loan would come out of the $5,000 that is still inside the policy.
It should be noted that loans cannot be taken out on term life insurance policies, because they have no cash value. These policies only offer pure death benefit protection for a set period of time.
When a Life Insurance Loan Makes Sense
As mentioned previously, life insurance loans can be useful if you need to get your hands on some cash quickly and it might be difficult to get approval from a bank or other personal lender.
Life insurance loans have no underwriting requirements and little to no paperwork to fill out. This is because you’re borrowing against your own money instead of using someone else’s.
Before you take out a loan against the cash value in your life insurance policy, consider the following factors:
- Find out exactly how the loan balance will affect your death benefit.
- Find out whether there is an “opportunity cost” to taking out a loan.
- Make sure that you can afford to make extra payments to repay the loan.
- Think twice before taking out the loan if you know that you will not be able to repay it. The in-for illustration for your policy can help you to see how this would impact you.
- Go over your policy with your financial advisor or life insurance agent if you intend to use the dividends or interest paid into the policy to make the interest payments on your loan.
Pros and Cons of Life Insurance Loans
There are several advantages to borrowing from life insurance as opposed to other sources.
Advantages of Life Insurance Loans
For one, the cash value in your life insurance policy can be a handy substitute for a traditional emergency fund if you don’t have one.
Life insurance loans also generally charge less interest than other types of personal loans, and they are also considered to be a tax-free return of principal, so that you won’t have to recognize the loan balance as income on your tax return.
The terms of a life insurance loan are also generally much more flexible than they are for traditional personal loans, and monthly payments may not even be required in some cases.
Life insurance loans also have no effect on your credit score, which makes them all the more valuable if your score is low or you have little to no credit history. And, as mentioned previously, life insurance loans have no underwriting requirements of any kind, so you don’t have to worry about qualifying for the loan.
You also do not have to tell the life insurance company what you plan to use the money from your life insurance cash out for, and you are free to use it as you see fit. You can use it to pay for anything from medical expenses to back taxes to home improvements or an exotic vacation cruise.
Furthermore, you may be able to take out a much larger loan from your cash value than you could qualify for from any other type of lender.
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