What Is a Policy Loan? – How Does a Policy Loan Work in 2023 ?
A policy loan is a type of loan that is offered by life insurance companies to policyholders. With a policy loan, a policyholder can borrow against the cash value of their life insurance policy. The loan is secured by the cash value of the policy, and the policyholder is required to pay interest on the loan.
Policy loans are typically offered by whole life insurance policies, as these policies have a cash value component that builds up over time. The cash value represents the amount of money that the policyholder has paid in premiums, plus any interest or investment gains that have been credited to the policy.
The amount that can be borrowed through a policy loan is generally a percentage of the cash value of the policy. The interest rate on the loan is set by the insurance company, and is typically lower than the rates charged by other types of lenders.
Policy loans can be a useful tool for policyholders who need access to cash, as they can be a relatively low-cost source of funds. However, it’s important to remember that policy loans must be repaid, and any outstanding loan balance at the time of the policyholder’s death will be deducted from the death benefit paid out to the policy’s beneficiaries.
How Does a Policy Loan Work?
Here’s how a policy loan typically works:
The policyholder requests a loan from their life insurance company, and the insurer agrees to lend them an amount up to the available cash value in their policy.
The loan is secured by the cash value of the policy, which means that the policyholder does not need to provide any additional collateral.
The loan agreement sets forth the terms of the loan, including the interest rate and repayment schedule. The interest rate on a policy loan is usually lower than that of a traditional bank loan.
The policyholder can use the loan proceeds for any purpose they choose, such as paying for a child’s college tuition or covering unexpected expenses.
If the policyholder does not repay the loan during their lifetime, the outstanding balance will be deducted from the death benefit paid to the beneficiary upon the policyholder’s death.
It’s important to note that taking out a policy loan can reduce the death benefit and cash value of the policy. Therefore, policyholders should carefully consider whether a policy loan is the best option for their financial needs and consult with a financial advisor before making any decisions.
What are the Pros and Cons of a Life Insurance Loan
Here are some potential pros of a life insurance loan:
Easy qualification: Because the loan is secured by the cash value of the policy, there are usually no credit checks or other requirements to qualify for the loan. This can make it an attractive option for those who may have difficulty obtaining traditional loans.
Low interest rates: The interest rates on policy loans are typically lower than those of other types of loans, such as personal loans or credit cards. This can result in lower monthly payments and less overall interest paid over the life of the loan.
Flexible repayment terms: Policy loans typically offer more flexible repayment terms than traditional loans. For example, some policies may allow the policyholder to skip a payment or pay only the interest due on the loan in certain circumstances.
No need for collateral: Since the loan is secured by the cash value of the policy, there is no need for the policyholder to provide additional collateral to secure the loan.
Tax advantages: Policy loans may be tax-free, which means that the policyholder will not owe taxes on the loan proceeds or on any interest paid on the loan.
Reduces the death benefit: If the policyholder does not repay the loan during their lifetime, the outstanding balance will be deducted from the death benefit paid to the beneficiary upon the policyholder’s death. This means that the policyholder’s loved ones may receive less money than they anticipated.
Reduces the cash value: Taking out a policy loan can also reduce the cash value of the policy, which can impact the policy’s growth and the amount of money that the policyholder can borrow against in the future.
Requires ongoing payments: Policy loans typically require regular payments of both principal and interest, which can be difficult to manage if the policyholder’s financial situation changes or they experience unexpected expenses.
Potential for policy lapse: If the policyholder is unable to make the required loan payments, the policy may lapse or be surrendered, which could result in the loss of the death benefit and cash value.
Limits investment opportunities: Because the cash value of a life insurance policy grows at a relatively low rate, borrowing against the policy may limit the policyholder’s ability to invest in other opportunities that offer a higher rate of return.