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Risks of Borrowing from your Whole Life Insurance

If you have enough equity in your whole life insurance policy, you may be able to use it as collateral on a loan.  You may even be able to borrow directly against the policy.  However it can take between 5 and 20 years to build up the equity sufficient to borrow from.   Once you do have enough to borrow, there are some risks which you should be aware of.

The ability to borrow from your whole life insurance policy is a prinicipal feature, but access the cash wisely.

Guaranteed Cash Value

The guaranteed cash value represents the funds that you can borrow from your whole life policy.  This is essentially a portion of the death benefit of the policy which has become liquid; it is available for your use.  The tricky part is that any funds which you borrow are subtracted from the value of the death benefit, and if you pass on before you have a chance to repay the loan, your beneficiaries will receive the funds they would be entitled to less the amount of the loan that is still outstanding.

Interest Expense

You should also know that the insurance company will charge you interest on any funds that you borrow.  Because that money is no longer available for the insurance company to use, and because they can no longer use that to get a return on the assets they’ve invested with your money, they charge the interest to help make up the difference.

A whole life insurance policy is in essence a mixture between a term life insurance policy and a savings account. However, it does not function in the same way as a savings account.  You may not borrow the full amount you have paid for the policy.  Only part of the premium which you pay each month goes to the investment that becomes your asset.  The remainder is saved to cover the death benefit paid out to your beneficiaries (these funds pay the premium on the term-life insurance policy component).

When Borrowing Makes Sense

If your credit is poor and you can only get money through advances on credit cards with extremely high interest rates, it might be wise to borrow from your life insurance policy.  However, if you have good credit and can get a low-interest signature loan, this may be a better idea as it will reduce costs and risk for you.

Another situation where borrowing makes sense is when you have an over-abundance of funds in the cash value account of the policy and your investment options are limited. If you have an investment opportunity that provides returns in excess of those you can receive through the investment options in your policy (and the interest that you will be charged), withdrawing those funds may make financial sense.

Risks of Borrowing

Because you do not have to repay any loan against your policy (the unpaid loan balance and interest are automatically subtracted from the death benefit received by the beneficiary) a problem can arise when you try to borrow too much.  When the loan amount and the policy’s cash value are close, there may not be enough money between the interest against the loan and the payments you make to cover the annual cost of the term insurance component of the policy. All premiums that you pay are added to the cash account of the policy. The insurance company then draws on this account to pay for the term life insurance premiums. If the amount of the premiums exceeds the balance in your cash value account, you may need to make up the difference by paying a higher premium or your policy may lapse.

Tax Benefits

Withdrawals from the cash value account of your whole life insurance policy is tax free up to the point of the premiums that you’ve already paid, and generally speaking, borrowed funds are not taxed either. However, if you are unable to pay the balance of the loan before your death, tax is assessed on the outstanding figure. A tax-free in-flow of cash is usually preferable to a taxable in-flow of cash. However, before you take any action, be sure to check with an accountant or other financial advisor to make sure that this information applies to your situation.

In Summary

One of the main benefits of a whole life insurance policy is the ability to access the cash value of that policy, either through withdrawal or borrowing. However, for most investors, whole life insurance policies are a life insurance policy first and an investment vehicle or savings account second. Borrowing against the cash value of your whole life insurance policy is a viable way to tap into equity, but it may also reduce the amount of the death benefit paid and/or increases the risk that you may not have sufficient funds to maintain coverage over the entire course of your life.

Policyholders who understand the risks and benefits of borrowing against their whole life insurance policy, and who work with an appropriate financial advisor to make financially sound decisions, will be able to realize the full potential of a whole life insurance policy. Policyholders who fail to understand these risks, may find themselves in a position where they have to either increase their premiums or risk the lapse of the policy.

As you shop for a whole life insurance policy, be sure to compare life insurance policies, both in terms of the cost as well as the features, to find a policy that offers maximum flexibility for your needs at the lowest cost. Our custom tools can help you find multiple insurers who operate in your area.

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