If you carry whole life insurance and have a bank account that’s been hard-hit by the coronavirus pandemic, you might consider borrowing against your policy. Tap your insurance in the wrong way, though, and you could create as many financial problems as you solve.
Unlike a term life policy, which has no value other than what it pays when you die, whole-life insurance has a cash value independent of the death benefit. You can borrow against that value as needed, as I did when I tapped my own policy for $500 decades ago. Given to me as a child by my mother’s father, and with a modest death benefit, the plan was to make sure that I would always have insurance, and to give me an asset that I could borrow against if need be.
Taking a loan from a whole life insurance policy might get you urgently needed money at a favorable interest rate. Handle the loan poorly, however, and you can sabotage your reasons for having the policy in the first place, lose the policy, or create an income tax bill that you can’t afford to pay.
Here’s a rundown of how to raid a whole life policy, along with advice on the wisdom of doing so compared with other potential options.
How whole life insurance works
Unlike term coverage, which protects for a stated period of time—twenty years is typical— whole life insurance stays in effect for as long as the policy is funded.
At the beginning of the policy and for some years, you fund the policy by paying level, annual premiums. Over time, with many policies, you receive dividends based on the insurance company’s financial performance, which you can use to offset premiums. Cash value also accumulates inside your policy, and you can borrow against that cash value.
The case for a loan
Borrowing against a policy’s cash value is a sweet deal in multiple ways. First, the insurance company can’t turn down your application for this loan. If there’s money available to borrow inside your policy, it’s yours to borrow, regardless of your current income or credit report. “They can’t turn you down for a loan unless you’ve already borrowed all the cash value,” says Chapel Hill, North Carolina-based financial planner Michael Whitman.
If you do tap the policy, the insurance company will probably charge you a favorable interest rate. “The better whole life policies have a low rate of interest for borrowing against the cash value,” says Michelle Gessner, a financial advisor in Houston, Texas. “Many of the good life insurance policies are charging less than 5 percent interest. Some policies have a zero cost loan if you've held the policy for ten years or more.”
The interest rate you pay to borrow is specified in the policy. What’s more, says Whitman, “the company might even pay the interest into your policy’s cash value.” In other words, you’ll essentially be reimbursed, albeit indirectly, for the cost of borrowing.
Once you’ve taken the loan, there’s no particular repayment schedule. You pay it back if and when you want to. That sounds like a helpful feature, and it can be. Yet it can also turn into a substantial disadvantage.
Repay the principal or reduce your policy benefits
No one will chase you down and insist that you repay the loan from your policy. But if you don’t, you could find yourself with at least one unpleasant surprise.
For one, you could capsize the reason that you bought the policy in the first place. “Whole life policies can grow tax-free, so people use them as retirement supplements,” Gessner says. “If you take a loan when you’re already in retirement, there’s no need to pay it back.” The loan is fulfilling your goal to provide retirement income. “But if you’re not in or close to retirement,” Gessner adds,”you’ll want to pay it back.” Otherwise, the money won’t be there to serve its original purpose.
People also buy whole life policies because their families plan to use the death benefit to care for loved ones or pay estate taxes. You’ll want to fully repay the loan if your heirs need the death benefit. If you die before full repayment, the outstanding balance will be deducted from your death benefit, just like any other loan.
Ignoring interest can collapse the policy
No one will make you pay the interest on your loan, either, and that could become an even bigger problem. “Say you borrow $10,000 from your contract at 5 percent interest,” Whitman says. “Every year, that 5 percent has to be paid back, or the interest will be added to the loan and capitalized.” If you don’t make interest payments, you’ll owe $10,500 by the end of the first year and $11,025 at the end of the second.
The insurance company will credit your dividend against your annual premium, interest, and principal. If the loan is small enough, the dividend might even repay it. That’s what happened with the $500 loan I took out against my policy.
For a bigger loan, though, the dividend will eventually be no match for the power of compound interest. Dividend payments won’t be enough to keep the policy afloat. If you’re not able to pay into the policy, the company will cancel it.
The taxman could cometh
As if cancellation of the policy for non-payment isn't bad enough, you’ll also owe income taxes on the difference between what you paid into the policy and the loan and interest payments you took out. “This is a trap for the unwary,” says New York-based financial advisor David Mendels. “The insurance company is happy to let you treat each unpaid interest payment as effectively a new loan. There’s no tax due until you either decide to or are forced to cancel the policy.”
At that point, all those interest payments and loan principal, minus premiums paid, become taxable as ordinary income. “It’s tough enough to pay taxes on income that you do get,” Mendels says. “It’s really hard to pay taxes on money that you didn’t get.”
You can take a loan and let the policy lapse on purpose, as long as you plan for the tax bill. That’s what Peter Lazaroff, a financial planner in St. Louis, Missouri, did when he bought his first house. He borrowed $30,000 against a whole life policy his parents bought when he was a baby. Three years later, the policy lapsed and Lazaroff paid taxes on about $15,000 — the difference between the premiums paid on the policy and Lazaroff’s loan principal and interest.
If you’re taking a loan because you’re short on funds, you would likely find it difficult to pay extra income tax. But if you know you can pay or offset the taxes — by taking a loss on a different investment, for instance — this strategy might work. Call your insurance company and ask for an in-force illustration to find out how much you can borrow and how long your dividend payments can keep the loan and policy afloat.
Overall, though, you should probably approach borrowing against a whole life policy with caution. “I wouldn’t rule it out, but it wouldn’t be my first choice,” financial advisor Mendels says. “Better choices might include a zero percentage credit card offer, a home equity line of credit, or an emergency fund.” Tapping retirement funds, he says, is a worse choice.