What Happens When You Borrow From Life Insurance?
Cash value life insurance is a specific type of insurance policy that builds a cash value savings. The policy provides death benefits that are payable to your beneficiary after you die, just like term life insurance. However, the cash value component offers you living benefits that are used during your lifetime. This cash value can be borrowed against, but you must understand how this impacts your policy.
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Types
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There are two types of policy loans available in most states. A fixed rate loan allows you to borrow money from your life insurance policy at a fixed interest rate. A variable life insurance loan gives you a variable interest rate that fluctuates with the Moody's Corporate Bond Index or other well recognized bond index.
Process
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When you borrow from your life insurance policy, you are not actually taking money out of the policy. The loan is a loan against the value of the policy. In this way, it's similar to a loan against the value of a home. The cash value represents "equity" in the policy. This equity secures the loan. Unlike most loans, there is no application process. You simply request the loan and the insurer sends you the money. There must be funds available in your policy to secure the loan. If there are none, then you cannot borrow any money against the policy. The insurance company issues the loan, then sets aside an equivalent amount of money from your insurance policy into a fixed interest account (for fixed rate loans) or leaves the cash value in the policy untouched (for variable rate loans). The interest on the loan is then charged to the cash value of the policy every year until the loan is repaid.
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Benefit
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The benefit of policy loans from a life insurance policy is that you do not have to repay the loan during your lifetime. If you do not repay the loan, the policy loan is deducted from the death benefit at your death and then whatever is left over is paid to your beneficiaries. Many insurance companies also use fixed interest accounts (in the case of fixed interest loans) or the policy's crediting rate (for variable rate loans) to offset the interest charged on a policy loan. This means that the cash securing the loan earns interest while the insurer charges interest on the loan they give to you. This often, but not always, results in a low or zero percent interest rate loan.
Disadvantage
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The disadvantage to policy loans is that the policy loan decreases the death benefit with each loan you take. This is because the loan is secured against the cash value. In a cash value policy, however, the cash value also represents part of the death benefit. This is why the death benefit is reduced with each loan. Also, there is no guarantee that the loan will be a zero percent interest loan. If interest is charged, it is charged to the cash values in the policy. This may result in the cash values being diminished over time.
Warning
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If the policy cash value reaches zero at any time, the policy will lapse. If this happens, then all of your policy loans are treated as withdrawals or distributions for tax purposes. This means that you must pay income tax on all of the gains in the policy. A gain is any amount of money in excess of the total premiums paid into the policy. These taxes are due in the year that the policy lapses.
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