Were you raised to believe that debt and policy loans are bad? In America, we’re often taught that a high credit score and zero debt are the ultimate financial goals. Ask anyone who has amassed a significant amount of wealth, however, and you’ll see that cash isn’t always king and that using a policy loan can actually be quite beneficial.
What are Life Insurance Policy Loans?
When you purchase whole life insurance from a mutually traded insurance company, your policy earns a guaranteed interest rate plus non-guaranteed dividends. Typically in the 4%–6% range, the interest rates and dividends you earn increase the cash surrender value of your policy. Cash value also increases with every insurance premium you pay. Part of your premium goes toward the death benefit of the policy, and part goes toward the policy’s cash value. As the policyholder, you can access this cash value for anything at all—tax-free—by using a policy loan. In this way, whole life insurance allows you to be your own personal bank.
Policy loans are private contracts between you and your insurance company. You don’t need a good credit score to be approved for a loan and using a policy loan won’t hurt your credit. You will be charged an interest rate by your insurance company, typically lower than a bank or other outside financier of personal loans would charge. You dictate the payback terms of your loan. If you have any outstanding loan balance when you die, it’s deducted from the death benefit of the policy.
Can I Default on a Life Insurance Loan?
Unlike a typically bank loan or credit card purchase, you’re not relying on anyone else’s money when you use a policy loan. You’re borrowing your own money, plus interest and dividends, from your insurance policy. The policy itself (the death benefit) is the collateral for your loan.
Your insurance company won’t let you take out a loan on your whole life insurance policy for more than the amount of cash value you have in the permanent life insurance policy (the amount in your “bank”). And because the death benefit will exceed the cash value in any whole life insurance policy (otherwise it becomes a Modified Endowment Contract, or MEC) there is always money available for the insurance company to recoup the amount of the loan.
If I’m Borrowing My Own Money, Why Not Just Pay Cash?
The benefits of banking with whole life insurance are easily misunderstood. Often, people think, “I don’t need a big loan; I’ll just save up cash,” or, “I don’t have any heirs, the whole life insurance cash value component doesn’t matter to me.” The truth is a whole life insurance policy offers a lot of benefits that you can’t get with other savings tools, regardless of whether you’re single or have a family to provide for.
There are 4 key reasons why it’s better to use a policy loan instead of relying on other savings tools like the stock market, savings accounts, CDs, or money market accounts. Regardless of what you’re buying, be it real estate, cars, vacations, business expenses, college education, or using a policy loan to help fund another investment, these same 4 reasons apply:
1. The “And” Asset
When you save money in a savings account, CD, or money market account (or in the stock market) you earn interest on every dollar you have saved. When it comes time to make a purchase, you withdraw some or all of that money and you no longer earn any interest (or you earn, but only on the amount left in the account). Because interest compounds, it may take a while to get your savings back to generating the same income you were earning prior to taking a withdrawal. You have to choose between earning money or spending money.
When you put money into a whole life insurance policy you earn interest (plus non-guaranteed dividends) on every dollar in your policy. When it comes time to make a purchase, you use a policy loan—but you still earn interest (and potential dividends) on the full value of your policy! Your interest continues to compound as though you hadn’t used the policy loan at all, ultimately increasing your wealth exponentially over time. You don’t have to choose between earning money or spending money. You can earn money AND spend money.
Now imagine you use your policy loan to help fund another investment or to pay for your business or personal education. These kinds of expenses generate their own returns ON TOP of the interest you’re earning on your insurance policy. By using policy loans, every dollar you put into whole life insurance can work twice as hard—even three times as hard!
Related: See the “AND” asset in action here.
2. Tax-Free Retirement Income
They say only two things in life are certain: death and taxes. But with mutually funded whole life insurance, the income tax part is flexible.
Whole life insurance policies offer a variety of tax advantages that can help you keep more of your hard earned money. First of all, the interest and dividends you earn in your permanent life insurance policy are tax-deferred. Should you withdraw the cash value of your policy (instead of using a policy loan) you would be taxed on your earnings. But policy loans are tax-free.
If you use policy loans to fund your retirement, you’re essentially increasing your retirement income because you’re not paying taxes on the various interest payments and dividends your policy has earned.
What if you want to retire before age 59 1/2? With a qualified retirement plan, you’ll be penalized an extra 10% on top of the taxes you’ll owe once you start taking distributions. And that whole line about “being in a lower tax bracket when you retire…” Who wants to make less in the future than they do now?! If you continue to increase your earnings in retirement, whether it be through investing, consulting, or freelancing, your taxes are at risk of increases as well. With policy loans, you don’t have to worry about taxes and you can use them at any age without penalties.
What about paying back the policy loan interest or loans? If you’re using your life insurance as your retirement savings, the goal is to have enough cash value that you continue to use policy loans for the rest of your life, just like if they were distributions from a qualified plan like an IRA, 401(k) or Roth IRA. At the end of your life, everything you’ve taken out in the form of a policy loan will be deducted from your death benefit. Your heirs may receive less, but the tax-advantaged wealth you were able to access during your golden years might be worth it, depending on your family’s situation and your financial goals.
3. Life Insurance Policy Riders
A unique feature of a life insurance policy is the ability to add policy riders, which function as additional permanent life insurance policies, and allow you to customize your policy. Some riders are free or can be added to a policy at a low cost. Riders can also provide you with increased cash flow in certain situations.
The Disability Waiver of Premium Rider
The disability waiver of premium rider is kind of like having insurance for your insurance policy, and if you think of your insurance policy as your own personal bank, it’s insuring your bank.
If you become disabled and unable to have sufficient cash value pay your policy premium, the insurance company will pay it for you if you have a disability waiver of premium rider. This means your policy won’t lapse (your personal bank won’t close) and you’ll continue to earn interest and dividends. You can use policy loans when you need them and enjoy tax advantages as though you were paying your policy premiums yourself.
Imagine being unable to work due to a disability and having to rely on savings. Every time you make a withdrawal, you earn less and less interest. Compare that situation to having whole life insurance, where your compound interest continues to grow even when you use a policy loan to supplement your lost income from work.
The Accelerated Death Benefit Rider
Also referred to by life insurance companies as a terminal illness rider or chronic illness rider, the accelerated death benefit rider provides you with an “advance” on the death benefit of your whole life insurance policy if you become sick. You can still use policy loans and your policy still earns interest and dividends, but you also get either a monthly payment or lump sum from the insurance company to help you and your family enjoy the time you have left.
Imagine the stress and frustration of having to rely on your savings to make your final wishes come true. With the accelerated death benefit rider, your life insurance company provides you with extra cash for your bucket list.
4. The Death Benefit
The main function of a whole life insurance policy is to provide your beneficiaries with a death benefit. When you structure a whole life insurance policy for cash value, the death benefit becomes secondary to the banking power your policy provides, but that doesn’t mean it’s not important.
Imagine you use a policy loan of $50,000 to buy a truck and you have $75,000 in cash value and a $500,000 death benefit in your insurance policy. Should you die before paying back the loan, your beneficiary would receive $450,000. This is the amount of the death benefit minus the amount of the policy loan. The remaining $25,000 in cash value is recouped by the insurance company.
If you pulled that same $50,000 out of a $75,000 savings account and paid for the truck in cash, your beneficiary would receive $25,000. Whose beneficiary would you rather be in this situation?
Are Life Insurance Loans Right for You?
Following broken financial advice is the reason many American’s aren’t more successful today. By using policy loans inside of a whole life insurance policy, you have the tools to be your own personal bank and get ahead, earning compound interest and potential dividends even when you borrow money from your own money.
Because your death benefit is the collateral for your loan, you don’t have to worry about defaulting or going into debt. Combined with life insurance policy riders, there are many ways to customize your policy to generate the cash flow and protection you or your family need.