Whole life insurance isn’t just for death. As the name suggests, it also has benefits that can last your whole life. One such benefit is the ability to borrow against your policy. More specifically, you can borrow against the equity of your insurance policy, also called the Cash Value. The Cash Value portion of your policy is entirely liquid, accessible, and a great savings pool! After all, every time you pay a premium, your “equity” in the policy grows. The Cash Value also earns interest and dividends.
We recommend borrowing against your policy via a policy loan in many cases, because it allows you to access your money without a withdrawal. While you do pay interest on the loan, your account also continues to earn interest and dividends on the full amount (rather than a reduced amount, which you can never put back).
Advantages of Borrowing Against Cash Value
1. It’s Straightforward and Fast
There’s no qualification process to take a policy loan. All you have to do is request the money from your insurance company. So long as you have the requested amount available in your policy (and it’s not already being leveraged), you can get access to a loan. There’s no application, no credit check, and no high fees or taxes (in most cases). Most companies can get your money in 5-10 days, yet sometimes you can get that money faster.
If you’re in a pinch and want some cash, you can be confident you’ll get it with a policy loan. If you went to the bank, you’d have lots of hoops to jump through, and no guarantee that you could access the cash you want.
2. It’s Flexible
With most mutual insurance companies, you can leverage up to 95% of your available cash value. When you borrow the money, you have the freedom to design your own repayment schedule and can modify it however you wish. In fact, should your circumstances warrant it, you can proceed without repaying the loan for as long as you wish (however, note that at some point this can drain your policy or create a taxable event).
Pretty much every other type of loan in existence has a strict repayment schedule, with strict terms, and may or may not be what you’re looking for. While we highly encourage and recommend repaying your policy loans diligently, sometimes a little breathing room is ideal.
3. It’s Affordable
Loan rates for a life insurance loan are running at about 4-8% right now. While that may seem high, it’s not quite equivalent to bank rates. The reason is because you’re also earning an internal rate of return on your cash value, likely of about 3-5% depending on your age and how long you’ve had the policy. Since you’re borrowing against your cash value and not withdrawing, your account continues to accumulate interest and dividends at the full value of the account. Ultimately, this offsets some of the interest.
4. It’s (Usually) Not Taxable
While a policy loan is not a taxable event on it’s own, we have to add the caveat. Like we suggested, the terms of repayment on the loan are entirely up to you. However, it’s often in your best interest to repay the loan to the best of your ability. That’s because eventually, without repayment, your loan can be considered income, if you owe more than you paid in via premiums.
However, just like taking a second mortgage or a line of credit against your equity, the IRS does not consider a policy loan income and does not create a taxable event unless you default.
What Happens to the Interest You Pay on a Policy Loan?
One of the most common misconceptions that we hear in regard to policy loans is that when you pay interest, you’re “paying it to yourself.” Unfortunately, this isn’t true. The life insurance company is loaning you their money, therefore, any interest you pay is going to the life insurance company.
However, as a policyholder, you do benefit from this. When you have insurance with a mutual company, you are a partial owner of the insurance company. The company must distribute any profits they make among policyholders. This is actually what the dividends are—profits. And the interest you pay in loans are a part of those profits. Mutual companies also tend to invest very conservatively in bonds, real estate, and some other, more certain assets.
As Todd Langford says in a Truth Concepts post: “This is a good deal for everyone because the insurance company earns money, the owner of the policy gets use of the money while 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 Your Cash Value
1. Fewer Assets Available
When you borrow against your cash value, you are putting a lien against your account for the value of your loan. This means that until you repay that loan, you won’t be able to access that specific amount of capital; it’s already leveraged. It works similarly to any line of credit. As you make payments on your loan, you regain access to your cash value for the value of those payments, minus the interest. In the meantime, however, the access you have to capital will be reduced. It’s important that you make good judgments on how to use your assets and when to leverage them.
2. Fewer Assets for Heirs
If you pass away while some of your cash value is leveraged, that reduces the death benefit paid to your heirs. The cash value is the equity of your death benefit, or the amount you can access. So if you pass away with $80,000 of your cash value leveraged, the death benefit will be paid after subtracting that $80,000 and any interest charges.
One solution to this is to fund PUAs, or paid-up additions, as you repay the loan. This means you’re buying a fully-paid micro policy that is attached to your primary life insurance policy. This increases both your cash value and your death benefit, which helps increase your personal capital and also what you leave to heirs. Your company will identify a certain amount of PUA you can buy each year.
3. Potential Taxes
If you choose not to repay your loan, you may eventually create a taxable event. Typically this occurs if you’ve borrowed more money than you’ve paid in premium, and then surrender your policy. Thanks to the interest and dividends, it’s entirely possible for you to borrow more than you’ve put into the policy. In fact, there’s a “break-even” point in every policy where your cash value finally equals more than you’ve contributed. You cannot lose money in a policy, so once you hit this point (often about 7-10 years into the policy) you don’t “go back.” However, you need not worry about paying taxes unless you choose to give up your policy, and at this point most people see how valuable it is to save into whole life insurance.
Another way you might pay taxes on a policy is if you’ve over-funded policy. This might occur if you try to buy too much PUA. Over-funded polices are called MECs, or modified endowment contracts, and are policies that don’t follow specific IRS guidelines (put in place to prevent money laundering and tax shelters). If you do have a MEC, you must pay taxes on policy loans. Fortunately, there’s no way to accidentally have a MEC. The first line of defense is your agent, who designs a policy that doesn’t MEC (unless you choose to have one). The second line of defense is the insurance company, which will send you a letter alerting you if you attempt to over-fund your policy.
4. Cash Value is Your Policy’s Emergency Fund
You may be using your cash value as YOUR emergency/opportunity fund, yet remember that the cash value is also your policy’s emergency fund. By that, we mean that your cash value acts as collateral for all of your policy loans. Your cash value can also be a line of defense for times when you struggle to pay your premium (if your agent has added the correct policy rider). So if you cannot repay your loans, and you’re also struggling to pay premiums, your policy may “implode.” This can create a taxable event and leave you with very little in the end if things go south.
While whole life insurance is backed by many guarantees and is an extremely powerful way to save and build capital, it hinges on you living up to your part of the contract. You promise to pay a certain amount of money for a certain amount of time. As long as you do that, the insurance company must live up to all its guarantees.
Should YOU Borrow Against Your Cash Value?
If you want access to your cash, borrowing against your cash value can be a great way to get it. Yet if you aren’t sure about when or how you’ll repay your loan, there’s no harm in talking it out with your advisor! They can help you determine the best course of action. In some cases, you may choose to get a loan somewhere else in order to get a better interest rate, and that’s okay! You might choose to just use what you’ve got in the bank, instead of leveraging your dollars, and that’s okay too. The point is that whole life insurance gives you the freedom of choices.
If you want to start building your own savings through whole life insurance, or you have questions about how to put your policy to use, contact us. We’d be happy to put you in touch with a Prosperity Economics Advisor.