Here’s What Happens When You Borrow Your Life Insurance
You can borrow against next week with a payday loan and against next month with a credit card. You can even borrow for your own retirement with a 401 (k) loan. But what about a life insurance loan? Well, it won’t affect your afterlife, but your heirs might not like it. If you can overcome this drawback, a life insurance loan can be a viable option for quick emergency cash.
According to a insurance report According to research organization LIMRA, nearly 60% of decision makers in US adult households are covered by some form of life insurance. These policyholders requested coverage for burial costs, income replacement, inheritance and debt repayment after their death. Life insurance is less sought after for the benefits it provides to policyholders during their lifetime. Specifically, permanent life insurance policies accumulate cash that can be used in an emergency.
Generally, debt is not the preferred way to cover emergency expenses. But if you don’t have emergency fund, you may not have a choice. And when you consider the options – using a credit card or borrowing against your 401 (k) – a life insurance loan may be the easiest to manage. Unfortunately, it is also the most difficult debt option to understand. Here are five consequences you’ll accept when you borrow against your life insurance policy.
1. Your monetary value does not change
The funds for your life insurance loan do not come from the cash value of your policy. Instead, the insurer loans you money directly and uses your cash value as collateral. This distinction is important because it means that there is money left in your contract and that it continues to generate investment income while the loan is in progress. It’s quite different from a 401 (k) loan, which withdraws the funds from your pension plan and reduces the return on your investment in the future.
2. Your death benefit is reduced
As long as you have an outstanding loan on your policy, the death benefit is reduced by the loan amount plus interest. Suppose your policy’s death benefit is $ 150,000. If you borrow $ 10,000 and die immediately, your heirs will only receive $ 140,000.
3. You incur interest, but the repayment is unlimited
As you might expect, you will be paying interest on your life insurance loan. The rate is set by the insurance company and can vary from 4% to 8%. Often, the insurer will charge you the interest annually on the renewal date of your premium. If you don’t pay the interest charges, they will be added to your loan balance where they will earn additional interest. This can snowball quickly, eating away at your death benefit.
What you cannot expect is that the insurer does not establish a repayment schedule for the principal. How and when you repay these funds is up to you. Technically, loan repayment is usually optional, but there are some advantages to doing so. You would restore the death benefit and stop accruing interest charges.
4. You must continue to pay your premiums
Your policy may allow you to use the accumulated cash value to pay your insurance premiums. This advantage disappears when you borrow because the money is now used to secure your loan.
5. You may have to pay taxes if you let the policy expire
Life insurance loans are not taxable when the contract is active, but they could become taxable if the contract expires for any reason. Basically, the Internal Revenue Service sees a taxable gain when the cash value of your expired policy is greater than the total premiums paid. Outstanding loan balances are problematic because the insurer will pay off your loan from your cash value. This means you could end up with a tax bill and no money to pay it.
Here is a simplified example. Suppose you maintain your policy for 15 years and pay a total of $ 15,000 in premiums. The cash value is $ 18,000 and you borrow all of it. If you stop paying the premiums and the insurance company cancels your policy, you will not receive a payment because your cash value will be used to pay off your loan. However, you will have to pay taxes on the difference of $ 3,000 between your cash value and your total premiums paid.
Stay up to date on interest and premiums
Avoid the worst consequences of a life insurance loan by staying up to date on interest charges and your annual premiums. Also add a line in your budget for emergency fund savings. When bad things happen, a cash fund offers much more flexibility and fewer inconveniences than any type of debt.