Many of your clients purchased a permanent life insurance policy years ago, dutifully paying the premiums and building cash value along the way. They understand the value of life insurance during retirement. This cash value may now represent a source of funds to pay for a variety of financial needs, including retirement income, buying a property or paying for a child’s wedding.

Tapping into this source of capital, however, comes with advantages and disadvantages that every client needs to carefully consider when borrowing against life insurance

Advantages of Borrowing Against a Life Policy

Insurance companies typically allow policyholders to borrow up to 90 percent of the cash value in their policy. Here are some key benefits:

• Lower Borrowing Costs—Most insurers offer rates below what banks may charge on personal loans, though individuals should compare rates on all available loan types.
• Quick and Easy—Unlike most loans, borrowing against cash value requires no approval process or involved application. Borrowers usually get their cash within two weeks.
• Repayment Flexibility—Borrowers can repay in an amount and frequency of their choosing, without being locked into a scheduled payment plan.
• Does Not Affect Credit Score—Loans from life insurance policies, unlike conventional loans, are not reported and do not impact credit scores.
• Alternative to Surrendering—Individuals considering surrendering their policy to access cash or because they no longer need coverage may be subject to taxation on that surrender. However, a loan against cash value accesses that policy’s value without tax consequences.

Disadvantages of Borrowing Against a Life Policy

Borrowing against a policy’s cash value is not without its drawbacks:

• Reduced Benefit for Heirs—Should a policy owner die with a loan outstanding, the death benefit is reduced by the amount owed. For example, if an insured has a $500,000 death benefit, with an outstanding loan of $150,000, the benefit paid out to heirs will be $350,000.
• Reduced Investment Returns—In cases of a variable policy, policy returns may be reduced if the insurance company moves the borrowed amount from an investment account to a safer option for the duration of the loan. In the case of whole life policies, borrowed amounts will continue to earn policy interest and potentially dividends.
• Tax and Policy Lapse Risk—Should the borrowed amount and accrued interest exceed the policy’s cash value, it may cause the policy to lapse, resulting in owing taxes (loan balance plus interest would be deemed income at that point) and the loss of financial protection for the policy owner’s family.

Advisors should remind clients that borrowing against cash value is not like borrowing from a 401(k), in which the participant is repaying the loan to him or herself; a cash value loan is taken from the insurance company, with payments made to the insurance company rather than the individual.

Want to understand life insurance as part of an asset allocation?  Click here.

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