You can borrow against next week with a payday loan and against next month with a credit card. You can even borrow against your own retirement with a 401(k) loan. But what about a life insurance loan? Well, it won't affect your afterlife, but your heirs might not appreciate it. If you can get past that inconvenience, a life insurance loan may be a workable option for fast, emergency cash.
According to an insurance report from research organization LIMRA, nearly 60% of U.S. adult household decision makers are covered by some form of life insurance. These policyholders sought out coverage for help with burial expenses, replacing income, leaving an inheritance, and paying off debt after they pass. Life insurance is less commonly sought out for the benefits it provides to policyholders while they're still living. Specifically, permanent life policies build up cash that can be tapped in an emergency.
Generally, debt is not the preferred way to cover emergency expenses. But if you don't have an emergency fund, you may have no choice. And when you look at the options -- using a credit card or borrowing from your 401(k) -- a life insurance loan may be the easiest to manage. Unfortunately, it's also the hardest debt option to understand. Here are five consequences you'll accept when you borrow from your life insurance policy.
1. Your cash value doesn't change
The funds for your life insurance loan don't actually come from your policy's cash value. Instead, the insurer lends you money directly and uses your cash value as collateral. This distinction is important, because it means cash remains in your policy and continues to earn investment income while that loan is outstanding. This is quite different from a 401(k) loan, which removes the funds from your retirement plan and reduces your investment performance going forward.
2. Your death benefit is reduced
As long as you have a loan outstanding against your policy, the death benefit is reduced by the loan amount plus any interest. Say your policy's death benefit is $150,000. If you borrow $10,000 and immediately die, your heirs will only get $140,000.
3. You incur interest, but payback is open-ended
As you'd expect, you will pay interest on your life insurance loan. The rate is set by the insurance company and could range from 4% to 8%. Often, the insurer will bill you for the interest annually on your premium renewal date. If you don't pay the interest charges, they'll be added to your loan balance where they'll accrue additional interest. That can snowball quickly, eating up your death benefit in the process.
What you might not expect is that the insurer won't establish a payback schedule for the principal. It's up to you how and when you repay those funds. Technically, the loan repayment is usually optional, but there are advantages to doing so. You'd restore the death benefit and end the accrual of interest charges.
4. You have to keep paying your premiums
Your policy may allow you to use accumulated cash value to pay your insurance premiums. That perk goes away when you borrow, since the cash is now earmarked as collateral for your loan.
5. You could incur taxes if you let the policy lapse
Life insurance loans are not taxable when the policy is active, but they could become taxable if the policy lapses for any reason. Basically, the Internal Revenue Service sees a taxable gain when the cash surrender value of your expired policy is more than the total premiums paid. Outstanding loan balances are problematic because the insurer will pay back your loan from your cash surrender value. That means you might end up with a tax bill and no money to pay it.
Here's a simplified example. Say you maintain your policy for 15 years and pay in a total of $15,000 in premiums. The cash value grows to $18,000 and you borrow all of it. If you stop paying the premiums and the insurance company cancels your policy, you won't get a payout because your cash value will be used to repay your loan. You will, however, owe taxes on the $3,000 difference between your cash value and your total premiums paid.
Stay current on interest and premiums
Sidestep the worst consequences of a life insurance loan by staying current on the interest charges and your annual premiums. Also, add a line item in your budget for emergency fund savings. When bad stuff happens, a cash fund offers much greater flexibility and less downside than any type of debt.