Can you borrow against life insurance? Yes. Should are you borrowing from life insurance? The answer depends on the cost of borrowing against life insurance.
In short, a policyholder who takes out a loan on a life insurance policy and repays it quickly enough to avoid interest charges may be acceptable. But an insured who takes money out of a life insurance policy without a plan may soon learn that life insurance loans can ultimately be more expensive than expected.
Life insurance loans can be tricky – terms vary widely depending on the company and the type of policy. When borrowing against life insurance, it is important to consider the downsides. For example, here are three of the financial consequences of borrowing a life insurance policy:
1. Aggravated debt
How interest works can be a bit tricky with a life insurance loan. Suppose an insured takes out a loan of $ 25,000 at an interest rate of 8%. The interest for the first year is $ 2,000. The policyholder can either pay the $ 2,000 out of pocket (with a principal payment if he wishes) or pay the $ 2,000 from the cash value remaining in his policy. If they choose to withdraw the cash value funds, that amount is added to their total debt, so they now owe $ 27,000. The following year they owe interest on $ 27,000, which adds another $ 2,160 to the debt, and so on.
There is a bit of “babysitting” that must go on after an insured borrows against life insurance, especially if it allows interest to accumulate. At some point, they can withdraw more money than they have in their policy, and the policy will expire. If the policy expires and is canceled, they lose everything they paid, no longer have the death benefit to bequeath to the heirs, and are likely to owe taxes on the money withdrawn.
2. Tax implications
As long as a policy is active, the accumulated funds are not taxable. However, it is considered a taxable gain when the cash value of the policy exceeds the premiums paid.
Here’s a simplified example: Suppose someone pays on a policy for 20 years. They pay a total of $ 20,000 in premiums and the cash value increases to $ 23,000. They borrow 85% of the cash value, or $ 19,550. They are in a difficult situation and stop paying the premiums. First, the insurance company accesses the remaining $ 3,450 in cash value to cover the premiums. Once those funds are gone, they cancel the policy. The IRS then says that the policyholder owes taxes on the difference between the cash value that was in the account ($ 23,000) and the total that he has paid over the years in premiums ($ 20,000 ), and sends him an invoice for $ 3,000.
3. Changes in death benefits
Any unpaid portion of a life insurance loan on the death of the policyholder is deducted from the death benefit. For example, if someone dies because of $ 60,000 on a life insurance policy valued at $ 500,000, beneficiaries receive $ 440,000.
An interesting note about permanent life insurance and death benefits is that insurance companies “absorb” any accumulated cash value. Let’s say a person has a $ 500,000 policy that has accumulated a cash value of $ 50,000. When they die, their beneficiaries receive $ 500,000, but the insurance company pockets the $ 50,000. The only workaround is if the insured has purchased a special rider that gives cash value to the estate.