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Is Borrowing Against Your Life Insurance a Good Idea?

When it comes to life insurance, not all policies are created equal. Certain types like whole, universal and variable life, allow you to build cash value in the policy as you pay your premiums. In fact, a life insurance policy could provide a solid alternative stream of income. This could come in handy if you run into financial trouble down the road or you need to make a large purchase. Of course, you’ll want to consider the pros and cons carefully.

How a Life Insurance Loan Works

A traditional bank loan usually requires a lengthy application process and a full credit check. A life insurance loan works differently. You don’t have to jump through any hoops to borrow from your policy. Typically, you can borrow up to the amount of cash value you’ve accumulated. The policy itself serves as your collateral.

Repayment terms for a life insurance loan are flexible for the most part. Depending on your insurer, you may not have to make payments toward the loan at all. When you die, the insurer will simply deduct the outstanding balance from the policy’s benefit amount. You can continue taking out new loans for as long as you’re paying the premiums. Just be careful to not overextend the policy and end up with negative equity.

Advantages of Borrowing Against Your Policy

Is Borrowing Against Your Life Insurance a Good Idea?

Being able to take money out of your life insurance in a pinch is a definite plus. This is especially useful if you don’t have an emergency fund or other investments you can withdraw cash from. Plus, you don’t have to pass a credit check or demonstrate proof of income to qualify. This works in your favor if you have a spotty credit history or haven’t had much luck finding a job. Additionally, if you’ve had the policy for a while, you can end up borrowing a much larger amount that what a bank might lend you.

Insurers do charge interest on a life insurance loan. However, you can often see much better rates than what you’d pay for a bank loan. The rates will be even better than if you took out a cash advance from a credit card. Just be sure you’re actively making payments on at least the interest each month or using your dividends to cover it. Then you can make borrowing from your policy a much more affordable option.

Drawbacks of Life Insurance Loans

One of the most problematic issues of borrowing from your life insurance is the impact it can have on your beneficiaries. Sure you can drain every penny of equity and quit making payments toward the loan. But then your loved ones will likely come up short once they need to cash in on the policy. Unless you leave behind other assets, they’ll have to bear the financial burden of paying for your funeral expenses or settling any debts or taxes owed by your estate.

Even though the interest rate on a life insurance loan may be low, it can compound fairly quickly. If you’re just paying the premiums and not adding in anything extra to cover what you’ve borrowed, the accrued interest could inflate the loan balance beyond the policy’s value. If that happens, the policy will lapse and you’ll have to surrender it to your insurer.

Aside from losing the policy altogether, you could potentially end up with a hefty tax bill. Generally, money you borrow from your life insurance isn’t treated as income. But loans can become a taxable event if you’re forced to surrender the policy. If you’ve cashed in on a significant amount of equity value, you could end up owing thousands of dollars in additional taxes.

What Are the Alternatives?

Is Borrowing Against Your Life Insurance a Good Idea?

If you’re not comfortable putting your life insurance policy at risk, there are other options for getting a short-term loan. A home equity loan or line of credit, for example, may be a possibility for homeowners. These loans usually have favorable interest rates. Your lender will consider your credit history and income before approving your application, though.

You might also consider borrowing from your 401(k) or taking an early withdrawal from your IRA. If you go with a 401(k) loan, your payments will be deducted automatically from your paycheck and you’ll pay interest on what you borrow. If you end up leaving your job before the loan is repaid, however, you’ll have to come up with the total amount due to avoid a tax penalty.

Taking money out of an IRA also has some potential tax consequences. Withdrawals from a traditional IRA are subject to income tax along with a 10-percent penalty if you take the money out before age 59 1/2. Qualified distributions from a Roth IRA are tax-free, but the early withdrawal penalty may still apply. Before you pull money out of your nest egg, you need to be aware of what it may cost you.

If you need some advice or you’re not sure which option aligns with your overall financial plan, consider talking to a financial advisor. The SmartAdvisor matching tool can help you find a person to work with to meet your needs. First you’ll answer a series of questions about your situation and goals. Then the program will narrow down your options from thousands of advisors to three fiduciaries who suit your needs. You can then read their profiles to learn more about them, interview them on the phone or in person and choose who to work with in the future. This allows you to find a good fit while the program does much of the hard work for you.

Photo credit: ©iStock.com/fotostorm, ©iStock.com/BernardaSv, ©iStock.com/Image Source

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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