Did you know that you can assign your life insurance policy to a lender as collateral for a loan? Bear in mind, that if you default or pass away before repayment of the loan, the lender is entitled to the death benefit. If there is any remaining balance, this will go to your beneficiaries. Additionally, this arrangement is only available for certain policies such as permanent life insurance, term life insurance, and cash value loans. If you are considering using your life insurance policy as collateral for a loan, here you’ll learn how to borrow against your life insurance policy and avoid common mistakes.
1. Borrowing More Than The Cash Value
If you are using permanent life insurance as collateral, make sure that the total cash value can cover your loan. If your policy dips below the cash value, the policy can lapse which means you’ll lose coverage and your beneficiaries won’t receive the death benefit. Also, loans against the cash value accrue interest, typically between 5%-8% per year. Be sure to account for this when borrowing against your policy.
2. Failing to Pay Premiums
If you fail to pay the premiums on your life insurance or cancel the policy, your lender could increase your rates or demand repayment of the loan in its entirety. You are required to keep the life insurance policy throughout the life of the loan. Additionally, there may be tax consequences if the policy lapses with an outstanding loan exceeding the total premiums paid. In this case, the IRS may classify the excess as taxable income.
3. Not Notifying Beneficiaries
Will your beneficiaries have enough to cover their expenses after the lender collects the remaining balance on your loan? Be sure to notify your beneficiaries of the loan against the policy. Especially if they will receive a reduced benefit.
4. Using a Term Life Policy with No Backup
If you are using a term life insurance policy, there is no cash value. Additionally, if the term expires before the loan is paid off your lender could demand additional collateral or repayment. So, using this as collateral could be risky. It’s best to include another form of collateral in addition to a term life insurance policy like savings, real estate, or other investments.
5. Forgetting to Remove The Lender after Loan Repayment
If you use your life insurance as collateral, the lender is given a collateral assignment on your loan. Once your loan is repaid, failing to remove the lender from your policy could make it difficult for your beneficiaries to receive the policy’s death benefit without complications. If the lender isn’t removed, they still may have a legal claim to your death benefit or your beneficiaries may need to prove that the debt was repaid. This could cause delays and additional legal steps.
Assessing How to Use Life Insurance as Collateral
Now that you know how to borrow against life insurance, it’s important to determine if this option is best for you. If you need a secured loan, using life insurance could be an affordable option to lower your rates without risking any other assets. Lenders are also often eager to accept life insurance as collateral.
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