Life insurance offers a valuable safety net for your loved ones in the event of your passing. However, it can also serve as a source of accessible funds during your lifetime through life insurance loans. While tempting, it’s crucial to understand how these loans impact your policy’s death benefit and cash value before taking the plunge.

What are Life Insurance Loans?

Life insurance loans are essentially borrowing against your policy’s cash value. This value accumulates over time from a portion of your premium payments in permanent life insurance policies like whole life and Universal Life. Term life insurance, designed solely for death benefit protection, does not accrue cash value and therefore doesn’t offer loan options.

Impact on Death Benefit:

The primary consequence of a life insurance loan lies in its direct reduction of the death benefit. When you borrow from your policy, the outstanding loan amount (including accrued interest) is deducted from the death benefit your beneficiaries receive upon your passing.

Here’s an example:

  • Death benefit: $100,000
  • Loan amount: $20,000
  • Interest accrued: $2,000

If you pass away without repaying the loan, your beneficiaries will only receive:

  • $100,000 (death benefit) – $20,000 (loan amount) – $2,000 (interest) = $78,000

This significantly reduces the financial support your loved ones receive during a difficult time.

Impact on Cash Value:

Taking out a loan also directly impacts your policy’s cash value. The borrowed amount is subtracted from the cash value, hindering its growth potential. Additionally, the interest charged on the loan further reduces the cash value accumulation over time.

Here’s how it works:

  • Cash value: $50,000
  • Loan amount: $20,000

After taking the loan, your cash value becomes:

  • $50,000 – $20,000 = $30,000

Furthermore, the reduced cash value can affect other policy features like automatic premium payments and paid-up additions. These features rely on the cash value to function, and a significant decrease can lead to policy lapse if not addressed.

Additional Considerations:

  • Interest Rates: While typically lower than traditional loans, life insurance loan interest rates can still accrue significantly over time, further reducing the death benefit and cash value.
  • Tax Implications: Unlike traditional loans, repayments on life insurance loans are not tax-deductible. However, the loan itself is not considered taxable income.
  • Policy Lapse Risk: If the loan, along with accrued interest, grows to exceed the remaining cash value, the policy might lapse. This cancels your coverage and leaves you with no death benefit or cash value.

Alternatives to Life Insurance Loans:

Before resorting to a life insurance loan, consider exploring other options:

  • Surrendering your policy: This allows you to access the cash value, but it cancels your coverage permanently.
  • Partial withdrawal: Some policies permit withdrawing a portion of the cash value without taking a loan.
  • Reducing your death benefit: This lowers your premium payments but also reduces the payout to your beneficiaries.
  • Seeking alternative loans:¬†Explore personal loans, credit cards, or home equity loans, considering their interest rates and repayment terms compared to life insurance loans.

Life insurance loans offer quick access to funds, but they come with significant consequences for your policy’s death benefit and cash value. Carefully evaluate your needs, explore alternative options, and consult with your financial advisor before making a decision. Remember, the primary purpose of life insurance is to provide financial security for your loved ones, and borrowing against it can compromise that purpose.