Bailey Scarano Blog

Life Insurance Loans: Risk-Benefit Analysis

Many people have been severely impacted by the economic downturn triggered by the COVID-19 crisis. Whether through job loss or some other factor, quite a few have found themselves in need of cash to pay unexpected medical bills, mortgage payments and other expenses. One option some are using is to borrow against the cash value of a permanent life insurance policy, but you should be aware of the risks. 

Recognizing potential pitfalls

Before you borrow against a life insurance policy, be aware of:

  • Reduced benefits for heirs. If you die before repaying the loan or choose not to repay it, the loan balance plus any accrued interest will reduce the benefits payable to your heirs. This can be a hardship for family members if they’re counting on the insurance proceeds to replace your income or to pay estate taxes or other expenses.
  • Possible financial and tax consequences. Depending on your repayment schedule, there’s a risk that the loan balance plus accrued interest will grow beyond your policy’s cash value. This may cause your policy to lapse, which can trigger unfavorable tax consequences and deprive your family of the policy’s death benefit.
  • Eligibility. You can borrow against a life insurance policy only if you’ve built up enough cash value. This can take many years, so don’t count on a relatively new policy as a funding source.

Tapping cash value

There can be advantages to borrowing from a life insurance policy over a traditional loan. These include:

  • Lower costs. Interest rates are usually lower than those available from banks and credit card companies, and there are little or no fees or closing costs. In addition, though you’re not paying the interest to yourself, your interest payments may benefit you indirectly if your insurer distributes a portion of its profits to policyholders as dividends. 
  • Simplicity and speed. So long as your insurer offers loans, there’s no approval process, lengthy application, credit check or income verification. Generally, you can obtain the funds within five to 10 business days.
  • Flexibility. Most insurers don’t impose restrictions on use of the funds. And you have the flexibility to design your own repayment schedule. You can even choose not to repay the loan, though that has negative tax consequences.
  • Generally no tax impact (as long as policy doesn’t lapse). Funds acquired by borrowing from a policy aren’t considered income, so they’re typically not reported to the IRS. This differs significantly from surrendering a policy in exchange for its cash value, which triggers taxable gains to the extent the cash value exceeds your investment in the policy (generally, premiums paid less any dividends or withdrawals). Note that interest paid on the loan typically isn’t deductible.

Reviewing your options

Be sure you really need to borrow from a life insurance policy before doing so. Consider alternatives, such as selling an asset or reducing expenses. We can help you make the right choice.