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A guy holding an umbrella that is holding both stack of cash and a car.
Ben Mounsey-Wood for Money

If you're trying to launch a business or borrow money for another purpose, you might be able to get a leg up from an unexpected source: Your life insurance policy.

The way it works is called a collateral assignment. The arrangement "is a lien, in essence, against the proceeds of an insurance policy,” says Michael E. Gray, Jr., owner of MEG Financial in Pensacola, FL. If the borrower dies before the loan is paid off, the lender gets first dibs on the death benefit to pay off the outstanding loan balance, and any remaining death benefit goes to the policy’s other beneficiaries.

“It’s very straightforward. That life insurance is there so that if something happens, it's less of a risk for the lender,” says Curtis Johnston, vice president and wealth advisor at King of Prussia, Penn.-based Girard.

Using a policy as collateral for a loan is sometimes confused with borrowing money from your policy — a lending option if you have a permanent life insurance such as a whole life policy that has an accumulated cash value. Although you’re essentially borrowing from yourself in a life insurance loan, and at a favorable rate, the move is not without its potential perils. If you don’t pay back the cash value taken from that policy, it reduces the death benefit and could mean higher premiums if you were using the invested returns of the policy’s cash value to offset your premium costs.

That said, collateral assignment of your life insurance also has disadvantages. If you default on the loan, the lender will have first claim to your policy’s death benefit. That makes it essential to understand this borrowing option, and to learn how to minimize its possible drawbacks.

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Learn where collateral assignment helps the most

In theory, collateral assignment can be used for a car loan or mortgage, but there’s often little need. With such lending, the home or car the loan helps to buy can become the collateral; if the borrower defaults, the lender can seize the asset to repay the loan.

Collateral assignment is most common — and is a common requirement — in small-business lending, insurance pros say. “Our bank is a preferred SBA [Small Business Administration] lender and the SBA requires it on most deals,” Johnston says.

Since most entrepreneurs sink most if not all of their savings into their ventures, they might not have many remaining sources of equity to tap. Unlike a mortgage, which lets the lender take the property if the borrower defaults, a failed business venture might not leave enough tangible assets of value for the lender to recoup their losses.

If an entrepreneur suddenly dies before their business takes off, the lender could be stuck with a loan that will never be paid off. (It’s also not uncommon for lenders to require businesses to carry life insurance on any executives whose sudden death would put the business at risk of folding.)

Understand which policies are best collateralized

If you’re required to have a policy naming your lender as a collateral assignee in order to get a business loan, Gray says most of those arrangements involve one kind of life insurance. “Traditionally the product that’s used the most is term life insurance,” he says, adding that working with an insurance pro who is well-versed in the process is important. “In these situations where businesses and loans are involved, it’s helpful to use someone that has experience working in these types of deals,” he says.

It’s likely that they will require the term of the policy to be at least as long as the length of the loan. From the lender’s perspective, “The best way to get the protection is to get the insurance policy for the length of the loan,” Gray says.

If you’re trying to use the value of a life insurance policy to help secure a mortgage or other type of personal loan, the lender might prefer if you have a whole or permanent life policy with accrued cash value — that cash value makes the policy a tangible asset, like a building or vehicle, Gray says.

“In terms of using life insurance cash value as collateral…that would be an asset,” he says. “That cash is cash, so whatever’s in that policy can be pledged against [the loan].” If you default on the loan but don’t die, a lender would have no way to recoup their losses as a collateral assignee on a policy without a cash value portion.

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Know your other obligations

If you already have a life insurance policy, you might be able to use that, or the lender might require the borrower acquire a new policy for the collateral assignment.

In addition to paying back the loan as agreed to in their agreement with the lender, you’re also required to keep current on the premiums of the life insurance policy for which the lender is an assignee and not let the policy lapse. Staying up-to-date on the premiums of that policy is a condition of the loan — and you can expect the lender to check, Gray says. “It would be in the contract for them to maintain the insurance,” he says. “Usually, they require proof every year or so. As the assignee, they would have permission to call into the insurance company for verification.”

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Be prepared when the loan ends

When the loan is paid off, the assignment terminates, meaning the lender no longer has a claim on your insurance policy, and the lender will need to provide you with documentation attesting to that. If you don’t get this documentation, follow up until you have it in hand.

While the lender still doesn’t have a claim on your death benefit once the loan is paid off, if you were to die, there might be a holdup for your beneficiaries to receive the death benefit if the insurer has to verify that the assignment to the lender has terminated.

Pick the right policy beneficiary

Gray says a common — and potentially very costly — mistake is to make a lender a beneficiary of a life insurance policy, rather than an assignee. With a collateral assignment, the lender gets first dibs at the death benefit money up to the amount of the outstanding debt, then any remaining funds are parceled out to beneficiaries. If the lender is the beneficiary, though, that would entitle them to the entire death benefit — which could leave the policyholder’s heirs with nothing.

“It’s a thing people need to be cautious about because it’s a commonly misunderstood situation,” Gray says.

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