The Dangers of Life Insurance Policy Loans – [Forbes Review]

One of the reasons some people buy cash value life insurance is the potential to borrow money from the policy later on. When you bought your insurance policy, the insurance agent may have touted that you would be borrowing your own money and paying yourself back.

Insurance agents and companies may promote loans as an easy way to receive tax-free money from your life insurance policy. However, policy loans are more complicated than they appear.

Policy loans need to be reviewed and monitored. If a policy loan is not monitored, a policy could slowly deteriorate, losing the minimum cash value needed. This can leave you with the unpleasant choice of making substantial loan repayments or having a large phantom income tax gain.

What is a Life Insurance Policy Loan?

Policy loans are available on most permanent cash value life insurance policies. Policy loans are not the same as other loans: Policy owners are not required to repay the loan. Keep in mind, the insurance company will charge interest on the policy loan.

When you borrow money from your life insurance policy, you are borrowing your own money. It is essentially an advance of money that could be received from the policy either through a surrender of the policy or the payment of the death benefit.  It is money that you, or your beneficiary, would have received anyway. The policy’s cash value acts as collateral for the policy loan.

If you never pay back the policy loan during your lifetime, the amount is deducted from the death benefit when you pass away—meaning that your beneficiaries repay the loan.

In Board of Assessors v. New York Life Insurance Company (1910), U.S. Supreme Court Justice Oliver Wendell Holmes wrote: “The so-called liability of the policyholder never exists as a personal liability, it is never a debt, but is merely a deduction in account from the sum the plaintiffs (the insurer) ultimately must pay.”

How Does a Life Insurance Policy Loan Work?

Life insurance policy loans are available on life insurance policies where there is sufficient cash value to borrow against. The available loan will be a percentage of the cash value.  You must pay interest on the policy loan.

To initiate a policy loan, you’ll need to contact your life insurance company. Before taking out a policy loan, find out what will happen to the components of your policy after the loan. You can do this by requesting an in-force illustration that will reflect the policy loan based on your plans—whether you’ll borrow more money, repay the loan or maintain the loan.

Be sure the in-force illustration also reflects whether you will be paying interest on the loan out-of-pocket or if you will be borrowing interest as well.

And review the following terms of the loan.