Can You Borrow From Your Life Insurance Policy? Pros & Cons to Consider
We’ll cut to the chase.
Can you borrow money from your life insurance policy and in effect take out a loan?
But, should you do it?
That’s where the answer becomes a little more complicated.
After all, you can borrow against the next two weeks with a payday loan and against next month with a credit card. You can borrow against your own retirement with a 401(k) loan.
But with a life insurance loan?
Granted, if things go wrong for you, it won't affect your afterlife, but your heirs might not appreciate it.
If you’re wondering how life insurance loans work and whether you should use it for fast and emergency cash and what the consequences are, we’ll spell out everything, the good, the bad and the confusing.
How Life Insurance Loans Work
First of all, you can only take out a life insurance loan if you have a permanent insurance policy (if you have whole life insurance, that’s a popular type of permanent insurance policy, and so, yes, you can take out a loan).
If you have term life insurance, as far as taking out loans, you’re out of luck and will want to look for some other way to borrow money.
But term life insurance is a good form of life insurance, and you are smart to have it, and you want to keep making those payments. If the unthinkable happens, your family will be covered.
Borrowing from life insurance
As for the mechanics of actually taking out a loan with a permanent insurance policy, you’ll simply go to your insurance policy’s website – or talk to your insurance agent – and you can get the ball rolling.
But, you may or may not be able to take out a loan.
With a permanent life insurance policy, you’ll pay your premiums, and there will be some money that goes to the death benefit (the money given to your heirs whenever you, er, exit the building).
And, some money that goes into a savings account, which you can use for loans.
If you haven’t created much of a cash value because you only started paying your premiums a few months ago, you may find that you can’t yet take out a loan.
As for how these life insurance loans work, your insurer lends you the money -- and uses the cash value in your policy as collateral.
That’s a good thing.
Your cash stays in your policy and continues to earn some investment income (but not as much as if you didn’t take out a loan; more on that later).
If you die with a life insurance loan
The death benefit will be smaller due to the loan.
Let’s say your kids were going to get $300,000 if something happened to you, and you’ve taken out a $20,000 loan.
If something happens to you before you pay off the loan, your kids will get $280,000. Still, a lot, in this hypothetical.
- There’s no credit check or laborious approval process, since you’re borrowing from your own money (your life insurance is the collateral).
- The interest rates tend to be lower than a bank loan.
- There usually aren’t fees associated with these loans.
- You’ll generally get these loans tax-free.
- You can usually get the money quickly (but not insanely quickly, expect to see your money in five to 10 business days).
- You won’t need to tell the insurance company why you need to use the money.
- There is no monthly payment for the loan – or even a payback date. In fact, you don’t even have to pay the money back. (But before you get too excited, check out the negatives.)
- There is interest with these loans. The interest can vary but is often around 5 to 9 percent, which may not sound bad, but sometimes it’s compound interest, and so you’re paying interest on your interest. That can get expensive.
- While you’re borrowing money from your life insurance loan, and you’re trying to pay it back, you also need to keep paying your insurance premiums.
- If you don’t pay the loan back, your family members will receive a smaller payout – they’ll in effect be the ones paying for the loan and its annual interest.
That’s exactly what you need to ask yourself before you take out a life insurance loan.
It’s easy to figure out what happens if things go right.
You borrow money from your life insurance policy, and you fix whatever financial emergency you have, and you pay it back at your leisure and then life goes back to normal.
If that’s what occurs when you need fast, emergency cash, taking out a life insurance loan can be seen as a reasonable move.
But if things go wrong?
There are consequences you'll accept when you borrow from your life insurance policy.
Reduced death benefit
Well, the loan sometimes will threaten the death benefit.
All policies are different, which is why you want to read the fine print and talk things over with your insurance agent.
But let’s say that you borrow a lot of money, and then one day, you’re walking outside and a grand piano comes careening from the sky, out of a building’s window, like in one of those cartoons, and you look up, and then the next thing you know, you’re playing a different tune -- with the proverbial harp on a cloud.
Meanwhile, you haven’t yet paid off the loan, and because you took out a hefty loan, and you didn’t read the fine print too carefully.
Your heirs receive far less of a payout than they would because you took out a life insurance loan.
So that would be bad.
Financial hardship could jeopardize the policy
You might struggle to pay off the loan and end up with so much interest and debt to pay back that you end up losing the life insurance policy altogether.
Some of the problem, too, is that along with that debt, you might be charged an “opportunity cost,” which can happen if you have a variable universal life policy.
If you have that type of policy, the moment you take out your loan, your insurer will take what’s called the loan collateral (cash that’s equal to your loan) and put it into a guaranteed or fixed fund, instead of an investment fund.
It’s safer but the money will earn less than the investment fund.
Also, you may be required to pay the difference to cover the money your insurer will lose by taking that loan money out of the market.
Taxes from a policy lapse
On top of that, if you do end up deciding you have to drop the policy because there’s nothing left for your heirs, remember that big loan you took out that was tax-free?
Now that the policy has lapsed, you could incur taxes.
But, again, look at your policy and think about your financial situation.
If you’ve been putting money away for years, and you have a lot invested in that life insurance policy, taking out a loan may be an excellent idea.
Things could go very badly or very well, with a life insurance loan, and you simply want to think about all of the angles.
When Does It Make Sense?
Everybody’s going to have their own opinion on this, but this borrowing money from your life insurance policy is probably a last resort type of situation.
But here are a couple situations in which it may make sense for some people:
- If you have a huge amount of money in a life insurance policy loan, and you only need to borrow a little, and you feel that you can pay it back easily, then it probably makes sense.
- If you are financially in trouble, deep trouble, and you have exhausted every other option to get money, and you feel that this is a decision that you’re comfortable with, even if you can’t pay it off, then, yes, maybe it makes sense.
But, again, this is a last resort type of situation.
Because it’s a life insurance policy, and you’ve been paying premiums all these years because you must really care about your family.
If something goes wrong, and you end up losing your policy, that’s a lot of money over the years that you have wasted. How are you going to feel then?
You may have bought this type of policy precisely because you knew if you were in a financial jam, this life insurance policy would allow you to borrow money against it.
And now you’re in a financial jam. So if that’s the case, maybe you bite the bullet and borrow the money from your life insurance policy.
Alternatives to Consider
Probably there are better alternatives to borrowing against your life insurance policy, ranging from good to terrible.
So much, though, on whether you take out a life insurance loan or some other alternative loan depends on so many factors.
- Are you employed right now?
- Is this money problem a short-term temporary fix, or something that seems like it’ll last?
- Do you have a long history of taking out loans and having things go badly, or have you always managed to pay back every loan you’ve taken out?
The answers to questions like that might help you make a wise decision.
At any rate, if you need fast, emergency cash, you might think about the following.
Apply for a credit card
What your credit limit will be depends on your credit score and credit history, but with minimum monthly payments, this may be a better option.
Take out a personal loan
Easy to say, not always easy to do. Your choices of personal loans can vary based on your credit score and credit history.
But a bank or credit union may be able to lend you what you need, and you’ll make fixed payments back in installments.
Even if the interest is kind of high, and it takes awhile to pay off, at least you aren’t risking your life insurance policy.
Take out a home equity loan
Also depends on the health of your credit, and it can be a process, taking out a home equity loan.
You may not have your money for a couple weeks or more. But it’s something to consider.
Borrow from your 401(k)
Getting the money can be quick (days, not weeks), and you won’t need a credit check. Fees are generally low.
But obviously, if you don’t pay it back, you could hurt your retirement portfolio.
Borrow from friends and family members
Sure, it may feel demeaning to ask.
Not knowing your friends and family, maybe this is a stupid idea.
But if you’re really desperate, you may want to consider it.
You can borrow money from your life insurance policy, and in some cases, it may even be a good idea to do it.
But you want to look over your policy very carefully. As with most loans, this isn’t a decision to make rashly.