If we had to choose one of the benefits of cash value life insurance that stands out as an excellent wealth building tool it would be life insurance loans. Having the ability to take out a tax free loan against the cash value in your policy whenever you want for whatever reason is a gigantic benefit.
Life Insurance Loans Pros and Cons
We will address these pros and cons within the context of this article but for brevity’s sake, here are some pros and cons of life insurance policy loans within the context of a mutual life insurance company.
- Your money continues to grow income tax free in your policy based on cash value guarantees and potential dividends
- You can pay back your loan at any time or never. You make the rules, although we do recommend you at least pay the interest.
- With the best cash value companies you will pay a low interest rate on the policy loan in contrast to other types of loans.
- You can take a policy loan at any time, and for any reason, with no credit check or qualification necessary.
- Unlike traditional retirement savings plans, such as 401k plan loans, there are no penalties associated with taking out a life insurance loan.
- Unpaid policy loans and accrued interest count against your total death benefit or surrender value at the time of claim or termination of the policy.
- Your policy could lapse if you are not diligent in monitoring it.
Now, before we start singing the praises of why life insurance policy loans are so fantastic, we need to bring in some context. At I&E, we believe one of the best vehicles for wealth creation is whole life insurance.
And when we say “whole life insurance”, we are referring to the best whole life insurance from a mutual insurance company.
In addition, the policy would be structured properly to allow the owner the ability to use the policy for personal financing.
So how does one use a policy for personal financing? You do this by implementing the strategies associated with the infinite banking concept®.
Please click on any of the links above to familiarize yourself with our philosophy of money via wealth and legacy building.
Now with that introduction aside, let’s get back to life insurance loans.
Loans on Life Insurance
The great thing about the best life insurance companies for building wealth is that they allow you to use the policy’s cash value as collateral and borrow up to 90% of the cash via policy loans, for whatever reason you need it for, anytime you want. Loan interest begins to accrue as soon as the loan is effective.
The players in life insurance consist of the company, the owner, the insured and the beneficiary. Sometimes the owner and insured are different, but often they are the same person.
You can think of your life insurance policy as a home that you either own or rent. Similar to term life vs whole life insurance, where you own your policy (whole) or you are renting your policy (term).
Cash value life insurance is more akin to home ownership. You own the policy and the equity in the policy, which is similar to owning the home and the equity in the home. You are the owner and as such, you may borrow against the policy at any time while the insured is living.
Term life insurance is more akin to renting a home, since you do not own the equity in the home. And chances are that when you most need the home equity (i.e. when you die) you are going to be kicked out (your term policy expires) before you can cash in.
The analogy only goes so far because one distinct advantage with permanent life insurance you can take out a policy loan whenever you choose, no questions asked. But with home ownership, if you want to tap into the equity you have to qualify. And a bank is going to ask a lot of questions, making it difficult to access your home equity when you need it most.
How do life insurance loans work?
When you take out a life insurance loan you are borrowing money from the insurance company’s general account, using your cash value as collateral.
So you are not actually borrowing your own money, but the insurance company’s money.
The cash value in your policy remains in your policy. The insurance company loans you money that was earmarked for policy owner loans, investing in bonds, investing in real estate, or investing in other investment grade securities.
Now here is a huge benefit; the cash in your policy continues to earn guaranteed interest and potential dividends, even though you took out a loan against your life insurance cash value. That means your cash value is continuing to grow via compound interest, even though you are using it as collateral to purchase other income producing assets!
Do Life Insurance Loans Have to be Paid Back?
No, life insurance loans do not have to be paid back.
If you don’t pay back your loan interest the carrier will simply add the interest to your outstanding loan balance. Interest on a life insurance loan is not due right away. Rather, interest is due on each policy anniversary date.
If interest is not paid when due, it will be added to the loan, provided it does not exceed the maximum loan available, and will bear interest at the rate payable on the loan.
And as you pay back your loan with interest, the money goes into the company’s general account, and not into your policy’s cash account.
Fixed vs Variable
The type of interest rate on any policy loan will vary on the carrier you choose and the options available with that particular carrier. Some companies offer a fixed loan rate. As of 2017, the average fixed loan rate on some of the better permanent life insurance policies ranges from 5-7%.
Alternatively, you can elect for a variable loan rate set by the insurance company. The rate changes from year to year.
Note that if you have certain riders, such as paid up additions or life insurance supplement riders, failure to pay interest on your loan when due may result in an increase to your minimum rider premiums.
What happens if I die with an outstanding policy loan?
Now if you die with an outstanding life insurance loan, your loan and any interest due will be taken out of your death benefit.
For example, if you owe $100,000 and your death benefit is $500,000, your life insurance beneficiary will receive $400,000.
This is the main reason why mutual companies are so ready to loan to policyholders—the money is secured by your cash value. There is no risk to the carrier.
In contrast, banks are much more cautious because the collateral a bank receives may not be as valuable.
For example, suppose you take out a real estate loan from a bank on a fixer-upper. The bank is using the property as collateral.
But what if you allow the property to devalue? The bank’s collateral has gone down in value.
And what if you default? The bank gets a dilapidated piece of real estate worth less than when the loan was given.
Hopefully this demonstrates why life insurance loans are so easy to take. And having easy access to this valuable asset can reap massive financial benefits when the time is right.
What Do I Use Loans from Life Insurance For?
Loans from life insurance can be used for anything. Here are just a few of the things you can use your loan for.
- Retirement Income. Supplement your retirement income with tax free policy loans as part of a solid life insurance retirement plan LIRP.
- Buy vehicles. Pay yourself back at the going interest rate and be your own finance company.
- Pay debts. Use your loans to pay down debt and pay your loan back with interest to supercharge your policy’s cash value.
- Buy assets, such as cash flow real estate. Consider using the cash flow to repay your policy loan. Once your loan is paid back, buy another property and use the cash flow to buy more cash value life insurance. Wash, rinse, repeat!
- Pay for college; yours or your kids. Consider life insurance for children as a great way to teach your kids about money and save for college and a future home.
- Invest in Business. Borrow money from your policy and loan it to your business. Have your business write off the interest and pay yourself back from your business.
- Pay for your daughter’s wedding. Recoup the cost of the wedding by charging yourself principle and interest on the borrowed money.
Are Life Insurance Loans Taxable?
As a general rule, life insurance loans are NOT taxable. Cash value life insurance obtains a favorable tax status under IRC 7702.
However, be aware that there is a potential taxable gain if your policy lapses or is surrendered while an outstanding loan exists. Any increase to your policy above your basis (i.e. what you paid into it) will be taxed as ordinary income.
If your policy is considered a Modified Endowment Contract (MEC), any loan you take will be taxable as ordinary income to the extent of the gain in the policy.
Further, if you are under age 59½, similar to a 401k plan, any taxable gain will incur a 10% penalty on top of any income tax owed.
Finally, for MECs, if you have loan interest due and you don’t pay it, the loan interest will be added to your principal balance and will be subject to income tax under the same rules.