Life Insurance – Policy loan vs collateral loan

BY: ANDREW STEWART 

We hear the word “loan” every day, it can be good for us personally or for our business. With so many options out there on where and how to get loans, it’s no wonder we tend to only view it as when we need to acquire money. But not all loans are created equal, these loans can actually be an asset to you by providing an income stream and the added benefit of not having to actually pay it back. Hold the phone did I just say to not pay back a debt? So, what are some of the key differences between taking a policy from your life insurance policy vs using it as collateral at a bank?

What is a policy loan?

A policy loan is simply an insurance company using the cash value of a life insurance policy to give money to the owner of the policy (unlike term life insurance, which does not accumulate cash value). Before, policy loans were issued at very low-interest rates, but now they can be as high as 7%. As cash value builds in a whole life policy, policyholders can borrow against the accumulated funds and receive the funds tax-free. It’s hard to say when a whole life policy cash value would be available for a loan although, it is generally accepted that at least ten years must pass before a policy loan is an option.

Another beneficial aspect is you don’t have to repay the loan. However, if the loan is not paid back before death, the insurance company will reduce the face amount of the insurance policy when the death benefit is paid. Interest can significantly cut into the death benefit, so it would be smart to at least make interest payments. Unlike traditional loans where you would need to qualify based on a number of factors, including credit rating, current, and future income levels, net worth, etc. There are no qualifications needed for this loan. Just simply call the insurance company and ask for the money.

Lenders are essentially taking a risk every time they approve someone for a loan; therefore, anything that can mitigate at least part of that risk is a vital part of their business. This is where collateral comes in, it reduces the risk that a lender takes on and also any loss that might come from a borrower defaulting.

What is leverage and how can you use it?

Leverage is, quite simply, taking out a loan. The loan can be secured or unsecured. A loan is secured when a specific asset is assigned as collateral security for the loan. The lender can, if necessary, seize the property provided as collateral and liquidate it to repay the debt. A real estate mortgage is a good example of a secured loan. If an asset is assigned as collateral security, the lender will also evaluate the nature of that asset (value, liquidity, etc.)

For example, residential real estate can be leveraged based on a 75% – 90% margin, meaning that if a house is worth $100,000, a bank will loan up to $90,000. At a 75% margin, a bank will loan $75,000. Now many lenders will provide the same benefit secured by a life insurance cash. You may use the loan proceeds to invest in a business or property, purchase other assets or pay living expenses. In these cases, the interest on the loan and a portion of the insurance premiums may be deductible for tax purposes. The tax savings can help reduce the cost of borrowing.

Once again when the borrower dies, the life insurance policy’s death benefit will repay the collateral loan. Any remaining death benefit will be paid to the beneficiaries designated within the insurance policy. You can also decide to pay the interest directly or add to the loan balance (known as capitalizing). When interest is capitalized, compound interest (interest on interest) will arise. This can be an issue with respect to interest deductibility. To ensure full interest deductibility, it is easier that the interest is paid annually out-of-pocket but each year a new loan is given for the same amount as the interest cost.

These two strategies are additional ways you can prepare and save for your retirement. If you want to learn more, contact your advisor for more information.