Is It Smart to Borrow Money From Your Life Insurance Policy?

lifeboyDesperate times often call for desperate measures. And while that may sound a bit dramatic, the recession that’s gripped the global economy over the past several years has left millions of families in that exact sort of situation. Unemployment has hovered around double digits for quite some time now, while most of a family’s regular monthly expenses continue to rise. Even highly qualified and motivated individuals often found themselves asked to cut hours or hunt for work for months and even years, forcing many people to empty their savings account and dig into emergency funds. You can only lean on your credit cards for so long, and that’s pretty dangerous behavior. If you don’t have a solid credit rating you won’t get an affordable loan, making things that much worse. So what’s left? Well, it is possible to borrow money from the equity you’ve built up in your life insurance policy. But is that a smart thing to do?

It’s an awfully tempting way out of a financial bind. After all, you’ve been paying the premiums on your policy month after month, and as long as you are healthy and maintain a relatively safe lifestyle, you probably don’t expect to need that policy for several decades. This quick cash option may have even been one of the reasons why you chose that particular policy. It’s also an incredibly simple process. You can borrow as much as the entire cash value you’ve generated, and unlike with a loan from a bank you don’t even have to pay that money back. Instead, the cash will be deducted from the value of the policy, reducing that payout at the end of the line. So it’s cut and dry then, right?

Regrettably, it isn’t. First of all, there are some costs you’ll have to keep in mind. You will be charged interest on the money you borrow from your policy. As with a bank, the interest rates will vary, but you can expect it to fall somewhere between 5% and 9%. And while you don’t have to pay the principle back, you do have to pay the interest. Whatever interest you leave unpaid each month will be added to the body of the loan. That means it will compound further, forcing you to pay interest on the charged interest.

You might end up with another expense, known as an opportunity cost. This will come into play if you’ve got a variable universal life policy. Remember, the money invested in the policy is treated as collateral in an investment. It earns interest, and that helps the policy grow. Once you borrow money, the remainder will be moved out of an investment account and into a guaranteed account. The insurance company depends on your money being there, consistently every month. So they’ll move it to strike it from their investments. The problem is, guaranteed accounts always earn less interest. And the insurance company will add the difference in earned interest, from the investment account to the guaranteed account, on top of your new interest rate.

One way to handle this is to tell the insurance company to pay the interest out of your policy’s dividends. But dividends in an insurance policy don’t work like they do in the stock market. You’re basically earning your money back, not earning additional money. Since you’ve lowered the amount of collateral the insurance company has to work with, you’re lowering the dividends you can expect back. That makes the loan more expensive, and could end up forcing you to come out of pocket on the interest. This will always be the case, regardless of which¬†life insurance brokerage¬†firm you work with. Forget this detail, and that interest could turn into a massive tax bill, one you will have no hope of paying off. So if there’s any moral to take from this, it’s to make sure you understand the risks top to bottom before going down this road.