5 Factors to Consider When Borrowing Against Life Insurance

Life insurance is not just a safety net for your loved ones in the event of your untimely death but can also serve as a financial resource during your lifetime. One aspect of life insurance often overlooked is the potential to borrow against the policy.

Here are five factors you should consider before making that decision.

When Can You Start Borrowing?

The first thing you should consider before you borrow against your life insurance is your eligibility to do so. Before you begin borrowing against your life insurance, you must ask yourself: how soon can you borrow against whole life insurance?

The answer lies in understanding the whole life insurance's cash value accumulation aspect. When you pay premiums, a portion goes towards building the cash value. Over time, this cash value accumulates on a tax-deferred basis and can be accessed during the policy's life.

However, it's important to remember that it doesn't build up instantly. In the early years, a more significant portion of your premiums goes towards the insurance cost and overhead expenses. The cash value typically builds up after you've held the policy for several years, typically 10–15 years.

Policy Type

The next thing to consider when you borrow against your life insurance is your type of life insurance policy. Only permanent life insurance policies like whole, universal, or variable life policies build cash value you can borrow against. Term life insurance, the most common type, does not have this feature.

Whole Life Insurance Policies offer consistency with a guaranteed death benefit, cash value accrual, and fixed premiums. The cash value component grows over time and can be borrowed against, making whole life insurance a potentially valuable resource if you need a loan.

On the other hand, Universal Life Insurance Policies offer added flexibility. This policy allows for adjustments to death benefits and premium amounts and accumulates cash value, which can be borrowed against. However, fluctuations in interest rates can affect the cash value, which might impact your borrowing capabilities.

Lastly, Variable Life Insurance Policies allow policyholders to invest their cash value into various accounts, offering the potential for greater growth. However, these policy types can pose more risk, as the cash value can decrease if investments perform poorly.

Loan Interest Rates

Interest rates on life insurance loans can have significant financial implications; thus, understanding them is crucial. It's not free money when you take a loan against your life insurance policy.

The insurance company charges an interest rate on the loan. While the interest rates on life insurance loans are generally lower than personal loans or credit cards, they are still a factor to consider.

The average interest rate on a life insurance loan is around 5–8%, which can accumulate over time if not paid back. Understanding this rate can help you gauge the cost of your loan over time.

Always review your policy, seek professional financial advice, and understand the implications of interest rates before deciding to borrow against your life insurance policy.

Impact on Death Benefits

Before you begin, it's essential to understand the ramifications of taking out a loan against your life insurance policy. Once you borrow from your policy, the amount you loaned, plus interest, is deducted from the death benefit if not repaid during your lifetime.

For instance, if you have a policy worth $100,000 and you take a loan of $20,000 (plus accumulated interest), the death benefit could be reduced to $80,000 or less when you pass away. The exact reduction depends on the interest accrued over time.

The outstanding amount will be deducted from the death benefits if you pass away before the loan is repaid. This could significantly reduce the amount your beneficiaries receive, which could be problematic if they rely on that money for financial support.

While a life insurance loan can provide immediate liquidity, it can significantly decrease the death benefit provided to your beneficiaries.

Tax Implications

Borrowing against your life insurance policy is not considered taxable income. This is because, in theory, you're borrowing against your money or, more accurately, the death benefit amount.

It's one of the key benefits of borrowing against your life insurance policy. While the loan might be tax-free, the interest accrued is not always tax deductible. This is because personal interest expenses typically aren't tax deductible, except in certain circumstances.

However, if your policy lapses or is surrendered and there's an outstanding loan against it, the difference between the cash surrender value and the loan amount (if positive) is considered income and could be subject to income tax.

You can consult a tax professional before you continue borrowing money from your life insurance if you're still confused about the tax implications it might have.

Final Thoughts

Borrowing against your life insurance policy can provide necessary cash during tough financial times, but it's not a decision that should be taken lightly. You must understand the potential risks and implications. Consulting with a financial advisor is always a good step to ensure you make a decision that aligns with your overall financial plan.