Traditionally called “life insurance loans,” a policy loan is issued by an insurance company that uses the cash value of a person’s life insurance as collateral. How does it work? As you pay your premiums, you build cash value in the policy. This is more typical for permanent life insurance, such as whole life or universal life. During the early years of the policy, the paid premium mostly goes to funding the indemnity benefit, but the cash value continues to increase as the policy ages. This benefit of life insurance could be useful if you run into future financial trouble, need to make a substantial and unexpected purchase, or need extra funding for new opportunities. However, just as you would with any other sort of loan, you should first compare and consider the pros and cons.
Pros:
- No qualification, verification, or application process. With most insurance companies, you do not need to pass a credit check, provide proof of income, or wait for approval. If you have recently gotten laid off, or have a spotty credit history, this could be a huge plus when in a pinch.
- Since there are no processes or approvals needed, the money is received significantly sooner than when compared to a bank loan. After making the request, a check is typically received in five to ten business days.
- Policy loans are non-taxable (as long as the amount borrowed is equal to or less than the amount of money paid on premiums) since the loan is borrowed from your assets.
- You do not have to specify how you want to use your loan. In some cases, when applying for a bank loan, you have to explain why you want the money, how you plan to spend it, and how you plan to repay it. With policy loans, you can spend your money in any ways you choose, and you determine how you pay off the loan. You could pay it off immediately or not make payments for years. The choice is yours.
Cons:
- The biggest issue with taking out a policy loan from your life insurance is the impact it could have on the beneficiaries. If you do not make payments on the loan, the accrued interest will be added to the principal balance of the loan before it could be cased in on. In some cases, the accumulated interest could eliminate the financial benefits of the insurance and leave family members the burden of paying medical and funeral expenses.
- While a pros of the policy loan is the flexibility and freedom, the effects of these pros could result in some hefty cons. For example, if you take a loan, there will be interest, which can add up quickly. Without making payments, the accrued interest could inflate the loan past its value causing the policy to lapse, and you will have to surrender your coverage. Once you’ve surrendered your insurance, the loans will become taxable, and you could end up owing hundreds to thousands of dollars in taxes.