Cash value life insurance loans: Pros and cons
Life insurance is often seen only as a safety net for your loved ones in case you pass away. However, certain types of life insurance also provide a living benefit known as cash value. Cash value life insurance policies, such as whole life and universal life, include a savings component that grows over time and can be accessed while you are alive. One of the ways to use this feature is through a policy loan.
Borrowing against your cash value can be an appealing option in many situations, but it is important to weigh the pros and cons carefully. Below, we will explore how cash value life insurance loans work and the factors you should consider before taking one.
What is cash value in life insurance?
When you pay premiums into a cash value life insurance policy, a portion of that money funds the death benefit, and another portion goes into a cash value account. This cash value accumulates over the years through interest or investment gains, depending on the policy type.
Over time, the cash value can become a significant asset. You can tap into it in several ways, such as making withdrawals, surrendering the policy, or taking a policy loan.
How do cash value life insurance loans work?
A policy loan allows you to borrow money from your life insurance company using your accumulated cash value as collateral. You do not need to undergo a credit check or fill out lengthy loan applications. The amount you borrow is not considered taxable income as long as the policy stays in force.
You can choose to repay the loan on your own schedule or let the insurer deduct the outstanding balance, plus interest, from the death benefit when you pass away.
This flexibility makes cash value loans an attractive option, but they also come with unique risks.
Pros of cash value life insurance loans
- Quick access to funds
Unlike applying for a personal loan or using credit cards, accessing cash from your policy is straightforward. There are no credit approvals or restrictions on how you use the money. - No impact on your credit score
Because you are essentially borrowing from yourself, taking a loan against your life insurance does not show up on your credit report. - Lower interest rates
Policy loans often have lower interest rates than unsecured personal loans or credit cards. This makes them potentially less expensive as a borrowing option. - Flexible repayment terms
You decide when and how to repay the loan. There is no set repayment schedule, allowing you to manage repayment in a way that suits your finances. - Continued cash value growth
In most policies, the cash value continues to grow even if you have an outstanding loan, although the net cash value available will be reduced by the loan balance.
Cons of cash value life insurance loans
- Reduced death benefit
Any unpaid loan balance, along with interest, will be deducted from your policy’s death benefit. This means your beneficiaries could receive significantly less money. - Interest accrual
Even though you are borrowing from your own policy, interest still accrues on the loan amount. If you do not repay it, the loan balance can grow over time. - Risk of policy lapse
If your outstanding loan and accrued interest exceed your policy’s cash value, the policy can lapse. This could result in loss of coverage and possible tax liabilities if the loan exceeds the amount you’ve paid in premiums. - Opportunity cost
When you borrow against your cash value, those funds are no longer available for other uses, such as compounding within the policy or being used later in retirement.
Important considerations
Before taking a loan from your cash value life insurance, ask yourself these questions:
- Is the loan for a short-term need, or will it remain unpaid for years?
- Can you comfortably repay the amount you plan to borrow?
- How will the loan impact the future financial security of your family?
- Are you prepared for the possibility that the death benefit could be much smaller?
A policy loan can be a helpful financial tool, but it is not a decision to take lightly. Always discuss your plans with your insurance advisor or financial planner to understand the implications fully.
Conclusion
Cash value life insurance loans can offer flexibility and quick access to funds without affecting your credit score. However, the potential drawbacks—including a reduced death benefit and risk of policy lapse—make it important to approach borrowing with caution. Understanding the pros and cons will help you make informed choices and ensure that your life insurance continues to protect your family as intended.