Dylan Habeeb- Products and Case Design
The words “life insurance” are generally associated with funds available at death. While this is true, there are also benefits to permanent life insurance that can be taken advantage of during one’s life, such as utilizing policy loans. A policy loan works by borrowing money from the insurance company and using the cash value in the policy as collateral.
When it comes to financial planning, saving for retirement is at the top of many clients’ lists. Most people will save money into their 401k, IRA’s, or (if a business owner) invest money back into growing his/her business. While retirement is an extremely important goal to plan for, it can make people lose sight of the years prior to retirement. There are many events where a client may need to have income available fairly quickly (i.e. emergency, college education, growing a business, home repair, etc.). This is where a policy loan can come into play.
Rather than being forced to go to a bank and apply for a loan, a loan from one’s permanent life insurance policy can save significant time and aggravation. Attempting to get a loan from a bank will typically require W-2s, tax returns, financial documents, as well as a solid credit rating. In addition, the current market rates for a bank loan may be higher than a policy loan interest rate. With a policy loan, a simple form is filled out and the money will be deposited into the client’s bank account in a couple of days.
Another difference between a bank loan and a policy loan is the repayment schedule. With a policy loan there is no fixed repayment schedule. A client may make a large payment one month and pay nothing the next two months. However, policy loans should be paid back as soon as possible, be it in cash or repaid from policy values, in order to preserve the soundness of the original contract. Paying off the loan will fully restore the benefits of the policy.
Choosing not to repay any portion of the loan can have severe consequences over time. Interest will begin to accrue which will be added to the loan amount. Clients need to monitor the activity of their loans regularly as the loan can grow quite rapidly. If a loan gets to the point where it equals the cash value in the policy, the policy will lapse (causing the insurance company to surrender the policy) and adverse tax consequences will occur.
If a client has cash value and a loan both equaling $100,000 then the policy will lapse. If the client paid $45,000 in premiums over the years this would be their basis in the policy. Therefore, there is a gain of $55,000 that will be taxed. If the client is in a 30% tax bracket then the client will owe $16,500 in taxes which will need to come from another source as the policy no longer has any value. This can all be avoided if the client and adviser actively monitor the loan and make regular payments.
The bottom line is that policy loans can provide an effective solution to business owners and other clients heavily concentrated in illiquid/inaccessible investments that are in need of a quick influx of cash. As with any financial decision it is important to speak with your adviser before taking action.