“A bank is a place that will lend you money if you can prove that you don’t need it.”
Two weeks ago we asked the question, “Should you borrow against your life insurance policy?” Today, we continue the topic by looking at the advantages and disadvantages of borrowing against a life insurance policy.
The Advantages of Borrowing Against Life Insurance
- It’s simple and relatively quick. There’s no need to fill out an application, qualify for the loan, or brace yourself for high fees and taxes (in most situations, see below exceptions.) You’ll have your loan in 5-10 business days for most companies, and occasionally they have faster options.
- It’s flexible. You can borrow about 95% of the cash value amount of your whole life policy from most mutual insurance companies. And when you borrow against your insurance policy, you can design your own repayment schedule, modify it as needed, or even continue down the path of life without repaying it if your circumstances require. In contrast, most types of non-insurance loans have strict repayment schedules that may or may not work well for you.
- It’s cheaper than you think. Life insurance policy loans are running in the 4 – 8% range right now. But that does not equate to a bank loan for the same amount. This is because you’re borrowing against an account that likely has an internal rate of return of 4-5%, depending on your age. And since you are borrowing against your cash value, not borrowing the cash value itself, your cash value continues to grow and earn dividends, which offsets the interest on the policy loan.
- It’s (probably) not a taxable event. Although there are exceptions, typically the IRS will never know that you borrowed the money. Like taking a second mortgage or line of credit against a rental property, a policy loan is not considered “income” in most situations.
What happens to the interest that you pay?
There is a misunderstanding with borrowing against your life insurance. Sometimes people say that you’re “paying yourself interest,” which is not exactly accurate. You’ve neither borrowed from yourself nor are paying yourself interest. You’ve borrowed from the insurance company, using your cash value as collateral. The interest is likewise being repaid to your insurance company.
However, in a roundabout way, the interest benefits all policyholders because in a mutually-owned insurance company, policyholders are paid dividends which represent profits. In a nutshell, interest on loans made to policyholders become earnings that later become dividends.
As the Truth Concepts blog states in a post entitled, “Life Insurance Loans: Where does the interest go?”
“This is a good deal for everyone because the insurance company earns money, the owner of the policy gets use of the money while at the same time their cash value keeps growing, and all the other policyholders know the insurance company is investing their money properly, since the interest charged is reflective of the rates in the marketplace.
The Disadvantages of Borrowing against Life Insurance
- Fewer assets for yourself. One disadvantage you always have when borrowing money from a life insurance policy (or a property) is that you’ll have fewer assets to use or borrow against (unless you are leveraging your asset to acquire a greater asset), plus of course interest to pay. So you always want to evaluate whether the loan is needed or not, or whether you can simply reduce your spending and avoid taking the loan in the first place.Always take the time to talk with your advisor or agent to understand the impact that borrowing against your policy will have. And don’t assume that just because you have “permanent life insurance” that you can or should borrow against it. Some forms, such as Universal Life and Equity Indexed Universal Life (EIUL) operate very differently from whole life insurance.(We’ll cover EIUL in another post soon. If you want to make sure you get updates, please opt-in here to receive our Prosperity Pack, and you’ll receive a periodic newsletter of our most recent posts, as well as some great resources to help you accelerate your prosperity.)
- Fewer assets for heirs. Although you don’t “have to” replay loans against your cash value, unpaid life insurance loans (and their interest) reduce total benefits to beneficiaries.One solution to this quandary is to fund some Paid-Up Additions, or PUA’s, as you begin to repay the loan. With a PUA, approximately 95% of the money goes to cash value, and about 5% or so goes to incrementally increase the death benefit. PUA’s raise the cash value amount available to you for use in future years, while also raising the death benefit for heirs.
- Potential taxes. Outstanding loan balances may trigger a “tax event” (typically the issuance of an IRS Form 1099) if you borrow more than you’ve saved (due to growth) and choose to cancel or surrender your policy at a later date.Certain types of “cash-rich” insurance policies have been designated “modified endowment contracts” (or MECs) by the IRS. Loans against MECs are not tax-free. If you suspect that your contract might be an MEC, be sure to ask about the loan’s possible tax consequences before you borrow. (A properly structured whole life policy will not be an MEC.)
- Cash Value is your life insurance policy’s “emergency fund.” If a high percentage of the policy’s cash value is borrowed and premiums are not paid on time, the policy may lapse, resulting in the loss of coverage (the “death benefit” paid to the beneficiary) and possibly triggering a further tax event.
Is there a better option than borrowing against your life insurance policy?
That depends on the situation. In some cases, there could be better options that have even lower costs. For instance, it might make sense to borrow from your 401k at low interest to purchase a house, and it’s hard to beat a tax-deductable Home Equity Line of Credit (HELOC) at today’s rates of as little as 3% APR.
Of course, there are generally fees as well as interest involved in borrowing money against a property, and now many lenders are charging substantial prepayment fees for short-term borrowers. Since the real estate market crash, it has also become much more difficult to qualify for those loans. Both the borrower and the property must fit lending requirements, such as sufficient equity, a steady job with income several times any debt payments, and good credit.
Borrowing from or taking money from retirement accounts can generate fees as well as taxes, and due to employer plan restrictions, some investors find themselves unable to borrow against their 401k’s, even in emergencies. When they can borrow, they will be typically limited to $50k or 50% of the vested funds, whichever is less. And unless the reason is a down payment on a home, the funds must be strictly paid back within 5 years.
The rules for IRA’s are even stricter. They are typically not acceptable as collateral and you can only access your funds for a 60-day period in what is considered a “tax-free rollover,” and that time frame is firm. Beyond the 60 days, you’ll pay income taxes, a penalty, plus lose the ability to put the money back in your IRA.
Should YOU to borrow against – or begin – a whole life insurance policy? At Partners for Prosperity, Inc. we use Truth Concepts™ financial software to compare different financial strategies. We show investors how to build wealth with safety, apart from market risks and instabilities. We can help you consider opportunity costs, taxation, risk and returns, and more. Contact us to find out more.