As one considers life insurance plans perhaps one of the least discussed features is the concept of taking out a policy loan. For those who may not know, a policy loan is how you can borrow money from the cash value of your life insurance policy. But what does that mean for your policy and its benefits?Â
In this blog, we are going to break down the basics of policy loans, how they may affect your life insurance plan, and what you should consider before borrowing.
What is a Policy Loan?
The policy loan is an advance availed on the cash value of a permanent life insurance policy, a whole life, or a universal life. Unlike term insurance, which never generates cash value, permanent policies create cash value over time. In this instance, policy loans allow access to this accrued cash value.
How Policy Loans Work
When you borrow against the policy, you are essentially taking money from the insurance company, with your policy’s cash value serving as collateral. The loan is usually relatively easy to get approved and doesn’t involve a credit check. The conditions on the loan, including how much interest is charged and the date it’s due, will be outlined by the insurance company.
How It Affects Your Life Insurance Policy
The death benefit provided is one of the most significant influences associated with the uptake of policy loans in life insurance. The death benefit refers to the amount that your beneficiaries receive upon your demise. If there’s a loan outstanding, then the insurance company will deduct the amount of the loan plus any accrued interest from the death benefit. For instance, if you have a $100,000 death benefit and you owe $20,000 on a policy loan, that means your beneficiaries will only receive $80,000.
- Interest Charged on Loans: Policy loans will generally be assessed interest charges. The rate varies according to the insurance company and, naturally, your policy terms as well. That fact is important because this interest will accumulate over time on the outstanding loan balance, piling up in addition to it. If it’s not paid, it accrues to the balance, which could be a pretty big amount over some time.
- Impact on Cash Value: The cash value of your policy is reduced by the amount of the loan taken out. If you don’t repay the loan, the cash value can continue to diminish as interest accrues. This reduction in cash value can reduce the policy’s ability to cover future premiums and could potentially lead to a lapse in the policy if the cash value falls too low.
- Policy Lapse: The policy will lapse when the loan balance with interest outweighs the cash value of the policy. When a policy lapses, your insurance coverage is ended, and you might also lose the benefits. To stop this from happening, you need to check the balance of the loan and the cash value continuously.
- Tax Implications: Policy loans are not usually considered income for taxation, as long as the policy remains in force and the loan is paid back. However, if a policy lapses or is surrendered while there is an outstanding balance on that loan, the amount of that loan may become taxable income. Because of the multitude of potential tax implications regarding policy loans, it is best to consult a tax professional.
Term Insurance vs. Permanent Insurance and Policy Loans
Term insurance and permanent insurance, such as whole life or universal life, are for different purposes and also have different characteristics. Term insurance is for a specified period, usually 10, 20, and 30 years, and it carries no cash value. Since term insurance does not hold any cash value, policy loaning against it cannot be considered.
On the other hand, permanent life insurance plans build up cash value, and this is the reason why policy loans can be issued. The permanent policies cover the lifetime of the policyholder, and on top of this lifetime coverage, the cash value would grow over time and develop into money that is available in case a policy loan is needed.
Considerations Before Taking a Policy Loan
Before taking a policy loan, review your financial needs and whether borrowing from your policy is your best option. You may find access to other funds at terms more beneficial than the insurance policy loan, such as personal savings or sources of traditional loans.
- Know the Terms: Read the policy loan conditions carefully, including the rate of interest to be charged, the repayment schedule, and any fees charged for the loan. Understand how this loan will impact your cash value and death benefit in your policy.
- Keep Your Policy in Check: Keep a close tab on the cash value of your policy along with the loan balance and interest charged on it. Regularly review all of your statements and remain in contact with your insurance company to avoid any surprises.
- Plan for Repayment: Have a plan in place for repaying the policy loan. Missed payments, or failure to pay back the loan, can result in interest charges on top of interest charges and a reduction in your policy’s benefits.
- Consult a Financial Advisor: Always, it is always recommended to consult a financial advisor or insurance expert before availing of any policy loan. They would guide you with potential consequences on the overall financial plan and would suggest the best option.
Wrapping Up!
Policy loans are one of the salient features of permanent life insurance plans that provide access to funds when required. They may be simple transactions, but they often have great implications and possible influences on the benefits of your policy. Being correctly informed about how loans against insurance policies work and what such a loan will mean for your life insurance policy will enable you to make appropriate decisions and manage your policy accordingly. Whether you own term insurance or a permanent policy, you must keep yourself informed and seek the counsel of one qualified to advise you so that your insurance coverage continues to meet your needs.
