Increasingly, Americans use personal loans to cover significant expenses. However, those with a cash value life insurance policy may find a better loan from their insurance provider. Let’s compare.
How Expensive is a Personal Loan?
According to TransUnion, personal loans are the fastest-growing lending category for consumers. FinTech companies are quickly becoming the de facto supplier for this type of funding, originating 36 percent of personal loans in 2017, which is up from less than one-percent in 2010.
Generally speaking, a personal loan customer is someone who meets the following criteria:
Needs emergency cash in a hurry
Either cannot or does not want to use a credit card or home equity for the expense
Wants to get the lowest interest rate possible without having to put up collateral
Online funding meets most of these criteria, with the most prominent exception being a low-interest rate. For those with poor to bad credit, a personal loan can be an expensive endeavor, or maybe not an option at all – especially for those without an income source.
Fool.com says that the average interest rate for a personal loan is 10.22 percent (which is less than the average credit card interest rate, which is 17 percent). Here are some APR examples:
Those with a 640 to 679 credit score tend to receive an APR from 24.46 percent to 33.01 percent.
Those with a 680 to 719 credit score tend to receive an APR from 17.19 percent to 26.02 percent.
Those with a 720 to 759 credit score tend to receive an APR from 10.69 percent to 19.97 percent.
Those with a credit score over 760 tend to receive an APR from 7.55 percent to 16.38 percent.
For many consumers, these fees are higher than what was initially expected – and, in some cases, unaffordable. The difference in just a few percentage points can translate to thousands of dollars over the course of a years-long personal loan. Loan customers who bite off more than they can chew often need to take out another loan to help pay off their first one, which can quickly turn into a vicious cycle of never-ending debt.
One way to avoid a costly personal loan is by borrowing from your life insurance policy. Here’s everything you need to know about using this funding source, from how it works to how to get started.
Why a Life Insurance Loan is Better than a Personal Loan
Here are some of the positives:
If the money is there, it’s there for the taking – meaning, sans credit check, approval process, proof of income, or extensive paperwork.
You decide the loan’s due date.
The interest rate will be significantly lower than what you would get with a personal loan.
Your loan will not show up on your credit report, which means lenders won’t see it if you need to take out another loan in the future.
The apparent downside to borrowing against your life insurance policy is that if you pass away before replenishing the account, some of the money won’t be there for your beneficiaries. Other negatives include:
Decreased dividends during the life of the loan
Being hassled by creditors that you are no longer protected from now the money is outside of your life insurance policy
Not being able to deduct interest payments from your taxes
The risk of having your policy lapse (more on this later – but for now, know that this is very bad)
These negatives can’t compete with the cost of taking out a traditional loan.
Wait, I thought there wouldn’t be interest since I was borrowing from myself?
One of the most confusing parts of borrowing from your life insurance policy is why interest is necessary. It’s because you are not borrowing your own money. Instead, the money is from the insurance company. Your policy is your collateral, meaning you can lose it if you never pay back the loan.
You should expect to pay anywhere between five to nine percent interest on your loan. If you do not pay down your interest, it will be added to the amount you borrowed, which can result in compounded interest. Depending on your policy, there may be other costs as well. For example, you should consider the opportunity cost of not having your money in your account helping earn more from your investments.
If you want to access the cash but not borrow from the insurer, you can surrender your life insurance policy and receive the cash savings associated with it. This might subject you to fees from the insurer, and you will need to pay income tax on the money gained. We do not advise this course of action.
What to Do Beforehand: Requesting Your In-Force Illustration
Your policy rep will provide you with an in-force illustration upon request. The report will show the affects the loan will have on your policy. It should include the implications of not paying back your loan.
Reviewing this report with your personal financial advisor is important. They will be willing to ask the hard questions and help you determine if this is the financial avenue you should go down.
How to Borrow from Your Life Insurance Policy
First, you need to find out if you have term life insurance or not. Term life insurance pays a beneficiary when the plan holder passes within the policy’s set term. This type of insurance cannot be borrowed from, as it does not accrue any cash value.
Permanent life policies, on the other hand, allow the plan holder to put money into the plan’s savings arm. The plan holder can borrow from this money, with the policy itself acting as the collateral. There are different kinds of permanent life policies. If you have Variable Universal Life Insurance, Variable Life Insurance, Whole Life Insurance, or Universal Life Insurance, then you should be able to borrow from your policy. Please note that some insurers will only let you borrow from your plan if you have had it for over 10 years.
Your insurance agent will be able to tell you if you have the right kind of plan, and then get the ball rolling for you.
Reasons People Borrow from a Policy
Here are some popular reasons people borrow from their life insurance policy:
Make a big purchase
Start a business
Pay an emergency expense
Take a vacation
Pay off other debt
Because of the risks associated with this type of funding, some financial experts think it is unwise to use it to pay for luxury items or vacation expenses.
What happens if I never pay it back?
Assuming the policy never lapsed, when the policyholder passes away the insurance company will subtract the amount owed from what the policyholder’s beneficiaries receive. Keep in mind that if your policy lapses, there may not be any payout. Even worse, you may need to pay income tax on the cash value of your policy (including the compounded interest). The most important thing to remember when dealing with this type of funding is never to owe more than what you borrowed. That’s when you must pay back the entire loan, and when the IRS considers the difference between the cash you borrowed and the original cash value of your policy taxable income.
Paying the tax is even worse than it sounds. A Bankrate.com article tells the story of a client with a $1 million policy cash value who borrowed $900,000 and never paid any interest on the loan. After 10 years of letting the interest compound, the client received a 1099 from the IRS for $1.6 million.
Nobody is going to make you pay your loan back, but you should do everything you can not to let it lapse.
Consider Your Beneficiaries
Many borrowers grapple with the possibility of not paying back the loan and thus depriving their beneficiaries of a portion of the insurance payout. By working with a financial advisor, you can put these types of fears to rest.
You may consider involving your beneficiaries in the decision, especially if they are adults. While it is your money and ultimately your call, being sensitive to their feelings and openly communicating with them can make for a healthier family dynamic.
Chances are you set up your life insurance policy for the sake of your children. As the years go by, though, you may see your children’s financial situation become more substantial than yours. If this is the case, the cash value of your plan might be more useful to you than it would be to your children when you pass.
A life insurance personal loan is superior to a traditional or alternative loan in nearly every possible way. It’s cheaper, less of a hassle, and a whole lot faster. It’s there because you were smart enough to set it up years ago. There are downsides, which we have discussed at length, but you can avoid them with financial prudence (or at the very least, professional guidance). If the option is available, you will likely be better off with it than an online loan.