Sometimes the unexpected happens and you need cash. Borrowing from your life insurance policy is one option.
Your cash-value whole, universal or variable universal life policy can appear a tempting source for a bailout, especially if you've been paying into it for years. After all, the quick-cash loan option was one of the features that sold you on permanent life insurance in the first place.
But before you borrow from your policy, consider the dangers ahead should you neglect to pay the interest on your loan -- or worse, trust that the dividends from your variable universal life insurance policy will automatically cover it.
"The biggest thing that people don't understand, including the agents selling it, is the intricate taxation that takes place inside a life insurance policy," says Al Barnes, a life insurance specialist in Alabama. "Borrowing from a cash value like that is sort of like building your house right on top of the San Andreas Fault -- only you don't know the San Andreas Fault exists."
Not Your Standard Loan
On the surface, a policy loan appears simple: You can typically borrow up to the cash value you've accumulated in the account. If you have a variable universal life policy, the insurer will move the loan collateral (a cash sum equal to your loan amount) out of your investment fund and into a guaranteed or fixed fund.
"We don't want to expose that collateral to market downturn that could result in negative equity in the policy to where you basically lose your policy," says Paul Wetmore, assistant vice president for individual life products at MetLife.
Unlike a conventional loan, you don't have to pay a policy loan back; any money you take out will simply be deducted from your death benefit, which goes to your beneficiaries.
But that's where the good news ends.
Costs to Consider
Exactly like a conventional loan, you'll be charged interest ranging anywhere from 5% to 9% on the loan, says Barnes. Unpaid interest will be added to your loan amount and will be subject to compounding. That's right -- you'll be paying interest on your interest.
"What people don't realize is that interest has to be paid. You're going to pay it either out of your pocket or you're going to borrow it (from your policy)," says Barnes. "It's exactly like borrowing on your home equity line. Just run an illustration of that and see what happens to your home equity."
If you have a variable universal life policy, you may also be charged an "opportunity cost," which is the difference between what your collateral was making in the investment account and what it will make in the guaranteed account. For example, if the invested portion of your account was earning 6% and the guaranteed fund earns a fixed 4.5%, you can add the difference, or 1.5%, to your interest rate to cover the earnings your insurer will forfeit by pulling that loan money out of the market.
Then there's the dividend issue. Dividends in life insurance are not like dividends in the stock market, which are a return on your money. Instead, they're essentially a return of premium, a return of your money, in part as a result of market exposure. When that loan collateral is pulled out of the market, your dividend will very likely go down for as long as you have the loan, further inflating your loan cost.
Unpaid Interest Can Create Trouble
If you pay your loan interest out of your pocket, you have little to fear. But if you instruct your insurer to pay your loan interest with dividends or by dipping into your policy, you could be headed for serious trouble. That's because if they fail to cover the full interest due, that unpaid interest will accrue as income and be added to the loan balance.
"One client with a policy cash value of $1 million borrowed $900,000 and let $900,000 worth of interest compound for 10 years, using dividends or loans to pay the interest. She called and said, 'I just got a 1099 from the IRS for $1.6 million!'" Barnes says.
Although it was what the Internal Revenue Service calls "phantom" income, meaning there was no corresponding cash flow, she was still on the hook for years of borrowing from her own policy.
The kicker is you may not discover how far in the hole your policy has fallen until you opt to drop it or your insurer notifies you that it's about to lapse, both of which constitute a taxable event that can prompt that heart-stopping IRS notice of tax due. And once you owe more than the amount you borrowed, you can't simply pay your way back into the black; you have to pay the whole loan back.
Wetmore says consumers should not venture into policy loan territory without a firm understanding of the risks. You can ask your insurance agent to run what's called an "in-force illustration" that shows the impact a loan will have on your policy.
"If I were to take a loan on my policy, I'm probably going to monitor that annually," says Wetmore.