“A penny here, and a dollar there, placed at interest, goes on accumulating, and in this way the desired result is attained.”
The Whole Life Insurance Dilemma: Taking Your Cash vs. Taking a Policy Loan
Need a chunk of change? Perhaps it’s an emergency, perhaps it’s an business opportunity, or it may simply be a periodic major purchase such as a new car. Either way, it’s bound to happen – you’ve got a need for cash, and you have to decide whether to get the cash from a credit card, a retirement account, a home equity line of credit, or somewhere else.
But wait! You’ve been saving just for such a situation, haven’t you? Yes, you have! You decide it’s time to take advantage of the money you’ve been tucking away – the money in your whole life policy your life insurance agent told you that you might need someday. You make a decision to utilize some of the cash value you’ve accumulated in your policy.
But how? Should you take a policy loan, or simply withdraw the money from your cash value? (Many people talk about “borrowing” their cash value but that is incorrect – you can either withdraw it, or borrow against your cash value.)
Withdrawing cash value is simple – you simply take it out and go! But there is a long-term impact, as you have now liquidated that part of your asset. Now there is less cash value left to earn dividends, grow for the future, or borrow against. There is also no interest charges or penalties to withdraw part (or even all) of your cash value.
Borrowing against cash value is also surprisingly simple. You typically have your money within a week, there are no qualifications required (other than sufficient cash value). Most companies will loan policy owners up to 90% or more of their cash value balance, while the cash value still earns dividends. However, you must pay interest on the loan, which currently varies between 5-9%, depending on the mutual company.
In this post, we’ll give you our rules of thumb to help you decide which is right for you – a cash value withdrawal, or a whole life policy loan.
Managing Your Whole Life Policy for Maximum Benefit
We are trained in the financial mainstream to avoid debt and “pay with cash.” So it might seem a no-brainer to just withdraw the funds rather than take a loan. But if you look at your whole financial picture and consider the potential future costs of this decision, you may see things differently.
Some questions to consider:
Do you have the means to pay a policy loan back?
If you have steady income, or even a history of steady income, policy loans make perfect sense. Perhaps you work on contract and are just in between contracts, or perhaps your income is not the issue, you just simply had a large expense or purchase. Even if it may take months, even years to pay it back, if you believe you can pay it back, the loan is the way to go.
If you cannot conceive of paying it back due to a continuing lack of income, (perhaps you are no longer working), a withdrawal is almost always the best choice.
How old are you? What are your circumstances?
If you are 90 years old, and no one is depending on your death benefit, you can still take a policy loan, knowing that it will be covered eventually by your death benefit.
However, if you are in your 70’s or even in your spry 80’s, but with limited income, you are better off withdrawing rather than borrowing against your cash value, because the costs of the loan (interest payments) will add up over time if you cannot pay the loan off.
If you are younger, the greater the negative impact of withdrawing becomes on your long-term savings. As a general rule, we advise someone who is active and has sufficient income to pay off a policy loan to borrow against their whole life cash value rather than withdraw. However, if you feel you have limited prospects for future income sufficient to repay the loan (and don’t want your life insurance to lapse), withdrawal is the better option.
Is your need for money temporary?
If you need the money for a limited time only, a policy loan probably makes the most sense. You don’t want to compromise your long term savings because of a temporary need, if possible. (But again, consider your age and circumstances.)
Are you using the money to create more money?
Our own Kim D. H. Butler was interviewed on the popular Real Estate Guys about how whole life insurance makes a great companion to real estate investing, because it’s an ideal vehicle to provide short-term cash for investments. With real estate investing (and many other businesses), you can have short-term cash flow needs, and be able to use that money to generate a return which allows you to pay off what you have borrowed.
We even have clients that borrow against their cash value to make short-term, fixed rate loans secured against real estate or other assets that can bring them returns MUCH higher than their cost of obtaining the money through the policy loan. (This should only be done very cautiously, but can be a powerful wealth-building strategy when carefully considered.)
Have you measured and considered your opportunity costs?
When making a major purchase such as new roof or a new car, many policy owners actually strategize intentionally to borrow against their life insurance cash value. In this way, they minimize the opportunity cost of paying cash.
We are trained to measure interest paid on debts, but what about interest not earned when people save in a bank and pay cash, rather than storing that money where it can grow? This is your opportunity cost, which is every bit as important to measure as the interest you’re paying (if not more so). We either “pay up or pass up” interest, and it is critical to have MORE MONEY working for you than less money, even if it creates temporary debts in the process.
(This may not make sense at the moment, but stay tuned for a future post for an example of exactly how this works. We’ll examine how cash value policy loans work like mortgages against a growing or appreciating asset.)
Some of the advantages to using a policy loan are:
- While you pay back your policy loan, the underlying cash value you are collateralizing keeps growing. Your cash value continues to earn dividends, which offsets the interest you pay. (We’ll give an example in a follow-up post.)
- There are no qualifications required for your loan, other than having the cash value to borrow against.
- You can pay back the loan on your own schedule, fast or slow, steadily, or in a lump sum.
- Interest is paid annually in advance, but if the loan is paid back early, you will receive a refund for the “overpaid” interest.
- Loans are tax-free (as long as your policy remains in force).
- Whole life policy loans do not affect your credit and are not tracked by the IRS, credit reporting agencies, banks, or anyone other than you and your insurance company.
- Should you find yourself unable to pay the loan, you could still pay for it with your cash value, liquidating that part of the asset, but erasing the loan.
The main disadvantage to policy loans are, obviously, the interest. Interest rates currently being charged for whole life policy loans are between 5 and 9%. And contrary to common urban legends, you do NOT pay the interest “to yourself,” at least, not directly. The interest is paid to the insurance company, and indirectly as a policy owner, that benefits all policy owners. (A whole life company is a mutual insurance company and is structured more like a cooperative than a corporation with stock holders.)
The main advantage to withdrawing is simple – you don’t have to pay it back! It’s your money, and you are free to take it without penalty or taxes – but only up to your basis.
Some cautions about policy loans and withdrawals:
- Withdrawals are treated as taxable income if you take more out then what you put in to the policy. If you withdraw repeatedly, you risk creating taxable events.
- Withdrawals reduce your current and future dividends, because it reduces your cash value, and your dividends are based on your cash value amount.
- When you withdraw money, you cannot “put it back.” That is simply the rule of insurance. You can pay NEW premium, but you cannot “put back” withdrawn money into your cash value.
- Policy loans, as well as withdrawals, do reduce your death benefit. (This is not a terrible thing in most cases, as a properly set up policy will have an escalating death benefit over time.)
- Interest does continue to accrue on unpaid policy loans. If you have no plan to repay, and you expect to live decades longer, withdrawing is a better option.
To Borrow Against or to Withdraw – Which is the Best Option for You?
It is essential to consult with a life insurance specialist before purchasing your cash value life insurance policy and they can help you construct your policy to meet your goals and objectives when it comes to taxes, death benefit payouts, income, even how you may wish to utilize policy loans.
If you do not currently have an advisor or agent versed in Prosperity Economics, infinite banking, or income for life strategies, please see our list of Prosperity Economics Advisors. http://partners4prosperity.com/advisors
Listen to our follow-up conversation on Guide to Financial Peace Radio: Should You Borrow from Your Life Insurance Policy?