“A bank is a place that will lend you money if you can prove you don’t need it.”
Months ago, we asked the question, “should you borrow against or withdraw from your life insurance policy?” Today, we continue with the topic of loans against life insurance, analyzing the advantages and disadvantages of doing so.
Reading: How much can i borrow from whole life insurance
the advantages of borrowing against life insurance
A life insurance loan can be a great way to access your cash while earning interest and dividends on all your savings. however, because you are taking out a loan against your policy, many people cancel this strategy. Here are some of the advantages we think make it worthwhile to borrow against your policy with a life insurance loan.
1. it’s simple and fast
There is no qualification process, no application to complete, income or credit verification, and no preparation for high fees and taxes (in most situations, see exceptions below). you will have your loan in 5-10 business days for most companies and sometimes they have faster options. This means that if you’re in a pinch and need cash for whatever reason, you can get it. the bank, on the other hand, can make you jump through hoops and fill out the paperwork and still reject your application.
2. is flexible
You can borrow about 95% of the cash value of your whole life policy from most mutual insurance companies. And when you borrow against your insurance policy, you can design your own repayment schedule, modify it as needed, or even continue down the road of life without repaying it if your circumstances require. In contrast, most types of unsecured loans have strict repayment schedules that may or may not work well for you. especially if you just want a little breathing room on your finances.
3. it’s cheaper than you think
Life insurance loans are in the 4-8% range right now. however, that is not equivalent to a bank loan for the same amount. This is because you’re borrowing against life insurance that likely has a 4-5% internal rate of return, depending on your age and how long you’ve had the policy. And since you’re borrowing against its cash value, without withdrawing the cash value, your account continues to grow and earn dividends, offsetting the interest on the policy loan.
4. is (probably) not a taxable event
Although there are exceptions, usually the IRS will never know that you borrowed the money. Like taking out a second mortgage or line of credit against a rental property, a policy loan isn’t considered “income” in most situations.
What happens to the interest you pay on a life insurance loan?
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There is a misunderstanding about borrowing against your life insurance. sometimes people say you’re “paying yourself interest,” which isn’t exactly accurate. you have neither lent to yourself nor are you paying yourself interest. What’s really happening is that you’ve borrowed from the insurance company, using its cash value as collateral. interest is also reimbursed to your insurance company.
However, indirectly, the interest benefits all policyholders because, with a mutually owned insurance company, they pay policyholders dividends (representing profit). Simply put, interest on loans made to policyholders turns into profit for the company, which translates into future dividends for you, the policyholder.
As the truth concepts blog states in a post titled “Life Insurance Loans: Where Does the Interest Go?”
“This is a good deal for everyone because the insurance company makes money, the policy owner uses the money while its cash value continues to grow, and all other policyholders know about the insurance. the company is investing its money correctly, since the interest charged reflects market rates.”
the disadvantages of borrowing against life insurance
1. less active for you
One drawback you can always have when borrowing money from a life (or property) insurance policy is that you’ll have fewer assets to use or borrow (unless you’re leveraging your asset to purchase a larger asset), plus of course interest to pay. so you always want to assess whether or not the loan is necessary, or if you can just cut your expenses and avoid taking the loan in the first place.
Always take the time to talk with your advisor or agent to understand the impact the loan will have against your life insurance! Don’t assume that just because you have “permanent life insurance” you can or should borrow against it. Some forms, such as universal life insurance and capital-indexed universal life (EIUL), work very differently from whole life insurance.
2. fewer assets for the heirs
Although you don’t “have to” repay loans against their cash value, unpaid life insurance loans (and their interest) reduce total benefits for beneficiaries. One solution to this dilemma is to finance some paid additions, or spikes, as you pay off the loan. With a PUA, about 95% of the money goes toward the cash value, and about 5% goes toward gradually increasing the death benefit. It can increase the amount of cash value available to you for future years, while increasing the death benefit for heirs.
3. potential taxes
Outstanding loan balances can trigger a “tax event” (typically the issuance of an IRS 1099 form) if you borrow more than you’ve saved (due to growth) and decide to cancel or surrender your policy at a later date. Certain types of “cash rich” insurance policies have been designated as “modified endowment contracts” (or MECs) by the IRS. loans against mecs are not tax free. If you suspect your contract might be a mec, be sure to ask about the potential tax consequences of the loan before you borrow. (A properly structured whole life policy will not be a mech.)
4. the cash value is your policy’s “emergency fund”
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If you have borrowed a high percentage of the policy’s cash value and do not pay premiums on time, your policy may lapse, resulting in loss of coverage (the “death benefit” paid to the beneficiary) and possibly triggers another fiscal event. Since cash value is like the equity in your death benefit, and since cash value acts as collateral for your loan, having an imploded policy like this can mean you end up with very little. you must have the discipline (and the cash flow) to save on your policy and pay off your loans.
Is there a better option than borrowing against life insurance?
That depends on the situation. sometimes there might be better options than life insurance loans that have even lower costs. For example, it’s hard to beat a tax-deductible home equity line of credit (heloc) at rates as low as 3% APR.
Of course, there are fees and interest involved in lending money against a property, and many lenders are now charging substantial prepayment fees for short-term borrowers. Since the housing market crash, it has also become much more difficult to qualify for those loans. Both the borrower and the property must meet loan requirements, such as sufficient equity, a steady job with income several times the debt payments, and good credit.
Borrowing or taking money from retirement accounts can incur fees and taxes, and due to employer plan restrictions, some investors can’t borrow against their 401k, even in emergencies. When they can borrow, they will generally be limited to $50k or 50% of funds purchased, whichever is less. and unless the reason is a down payment on a house, the funds must be repaid within 5 years. Another major issue is that you’ll have to replace the borrowed funds with after-tax dollars, which will then be taxed again upon withdrawal! (unless you’re a roth)
The rules for rage are even stricter. they are generally not accepted as collateral and you can only access your funds for a period of 60 days in what is considered a “tax-free transfer”, and that period of time is firm. beyond 60 days, you’ll pay income taxes and a penalty, plus you’ll lose the ability to pay the money back to your anger.
Should I borrow against or start a whole life insurance policy?
There’s no better time to start a whole life insurance policy than today, while you’re thinking about it. In addition to the benefits of a life insurance loan, there are also many advantages to having insurance. can protect your income and assets, helping you live life more freely knowing you’re protected. Plus, it takes some time to build up cash value. If you think you might someday want to use a life insurance loan policy, it’s a good idea to start saving now.
We can help you through the process of obtaining permanent life insurance and can tailor it to your specific financial and desired goals. if you’re ready, let’s get started.
At Prosperity Thinkers we use Truth Concepts™ financial software to compare different financial strategies. we show you how to create better methods of money and save money with certainty, in addition to the risks and instabilities of the market. we can help you consider opportunity costs, taxes, risk and returns, and more. contact us for more information.
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