Why You Should Be Careful With Life Insurance Policy Loans

Another reason why some people buy cash-value life insurance is the capacity to borrow money from the policy later on. When you purchased your insurance, the insurance agent may have mentioned that you would be borrowing your own money and paying yourself back.

Insurance agents may offer loans to policyholders to get tax-free cash from your life insurance policy. However, policy loans are not as simple to receive as they seem.

Life insurance policy loans must be reviewed and regularly tracked. If a loan isn't being monitored, a policy can slowly become neglected, causing the minimum cash value to decrease. This can be a disappointing choice: you may need to pay high monthly loan payments or have a large backdoor tax deduction.

What Is a Life Insurance Policy Loan?

Loans are available with most other permanent cash value life insurance policies. Life insurance loans are not like other loans. Be aware, the insurance company will impose interest on the loan amount.

Borrowing money from your life insurance policy is tantamount to borrowing money from your own assets. It is an advance of money that could be obtained from the policy either through a surrender of the policy or the payment of the death benefit. It is money that you would have received anyway. The cash value of the policy serves as collateral for the policy loan.

If you make a payment towards the loan during the lifetime of this policy, your beneficiaries will obtain an amount equivalent to the amount repaid.

How Does a Life Insurance Policy Loan Work?

The loan obtainable on a life insurance policy can be up to a percentage of the cash value. Technically, a term life insurance has no cash value. You have to have interest calculated on your loan.

The first step when attempting to obtain a policy loan is to contact your life insurance provider. Before borrowing money, ask yourself what will happen to your insurance policy components afterward. You can ask for an in-force illustration that will detail your insurance policy s value based on your actions before you decide whether or not to borrow more money, repay the loan, or keep the loan.

Make sure included illustration also reflects whether you will pay for all interest out of pocket, or will you also have to borrow interest also. 

And consider the following terms of your loan, the insurance company will charge interest in advance or in arrears.

Interest in advance

Interest late in the policy year indicates that the insurer charges extra interest for the entire policy year. This assumes that the loan is budgeted for that amount of time. If the loan is taken out in the middle of a yearlong plan, interest is calculated for the remainder of the policy year when the loan is taken out. The insurance company doesn't typically offer any credit and refund for the interest that was paid in advance if a payment is completed during the policy year.

Interest in arrears

Interest in arrears indicates the insurance company charges interest at the end of an insurance policy year. Interest accumulates daily. If a loan is taken out during a policy year, interest starts to accumulate that day. If you make a loan repayment during an insurance policy year, this would reduce the daily loan-interest amount.

The interest rate on an annual life-insurance loan can be fixed or variable. Fixed interest rates are guaranteed, so you will know what the annual interest rate on your policy loan will be ahead of time. Variable interest rates may change every year. Variable interest rates will be provided on your policy annual statement and with premium notices when annual interest is due.

The money you have withdrawn can still earn interest. The insurance company will pay you interest on the amount you borrowed, although this rate is usually lower that the rate offered to a single lump sum on the rest of the available cash. Accounts may have exactly the same interest rates.

Whole life insurance companies use the term recognition to acknowledge how considerably interest is credited to the value of the loan. If your life insurance firm utilizes the non-direct recognition method, you will obtain the identical dividend on all cash value. If your business utilizes the direct recognition method, you will receive the same dividend.

If you have an whole life policy, an elective automatic premium loan may be part of your policy. If you don't pay the due premium from your policy, it will be automatically deducted from the cash value through a policy of loan. Interest on a policy of loan is generally not tax-deductible.

How to Monitor a Life Insurance Policy Loan

The insurance company will not demand repayment of the loan balance. They do not provide any repayment schedule, either, nor do they pay any interest in excess of the amount paid each year. In the event that you elect to compound interest, the loan balance will accrue interest, which results in compounded amounts of interest.

It is important to request an in-force policy assessment on an annual basis to determine the results of policy lending. Your request should include these scenarios and any others that may accurately reflect your intentions when making the loan: 

• Making the insurance loan payment in full. 
• Paying premiums and the interest out of pocket. 
• Borrowing future premiums and the interest. 
• Showing what will happen if your present premium payments stay the same. 
• Showing the premium needed to endow the policy when it's mature. 
• Any other action you're considering, such as taking a partial withdrawal or changing your dividend option.

Why Is a Life Insurance Policy Loan Risky?

An in-force policy description will help you figure out how long your contract will remain in force as long as your principal remains outstanding. As the principal gets bigger, its influence on your policy gets bigger as well.

For example, the initial loan amount of $50,000 will be amortized at the rate of 8% if consolidated:

• The loan interest in year one will be $4,000. 
• If you borrow the loan interest, your loan balance will increase to $54,000 (initial loan amount of $50,000 plus the loan interest of $4,000). 
• The loan interest in year two will increase to $4,320.
• If the loan interest is borrowed, the loan balance increased to $58,320 ($54,000 loan balance plus loan interest of $4,320). 

As you can see, this quickly increases the loan balance.

Here's an example of how it works:

With a normal permanent life insurance policy, you can add cash value yearly till you die. However, the insurer pays out the death benefit only when it pays off the amount you owe, so the total risk to the insurer goes down as it gets closer to your death. Mortality costs the actual cost of insurance for you also increase every year as you age. That decrease is usually offset for the insurance business by the lessening amount at risk.

The cash value of your bank loan is impacted by the lower return on the cash you have lent. If your premium payments aren't enough to fix your mortality cost and other costs, the insurer is going to take it from the cash value. Now the cash value is being depleted with multiple payment demands and your loans, so your income is reduced.

If your policy is terminated, you'll incur a tax bill on certain borrowed funds.

Calculating Taxable Income from a Life Insurance Policy Loan

Here's an example of how to calculate the potential gain in the policy that is subject to income tax: 

• Add the net cash value, any past or accumulated dividends, and the outstanding loan balance. 
• Subtract the cost basis (the total of all premiums paid into the policy).

Example if a life insurance policy is terminated with a loan balance of $100,000 and a specific cost basis of $50,000, the taxable gain would be $50,000. 

Please note that the above example is a general rule and may not apply to every situation. You should consult your tax advisor to confirm whether you have a taxable gain.

Life insurance businesses have the ability to supply you with the cost basis, as well as the gain that's reported to the IRS as 1099 income.

 If you'd take a life insurance loan, consider the possible adverse effects. Know what you're getting into before choosing to take the cash offered.