Term life insurance doesn’t build cash value, but other types of life insurance do. Whole life insurance, which is also called permanent life insurance, offers a death benefit and also accumulates cash value you can borrow against.
“Cash value life insurance” serves multiple purposes. Not only does it protect your family in the event of your death, it serves as a financial resource you can lean on when it makes sense.
Borrowing against cash value life insurance is a decision that is dependent on individual circumstances and goals. The best advice is to read up on the expert advice out there until you’ve developed a solid understanding of the advantages and disadvantages of borrowing from your policy. That way, you can make an informed decision that is based on your circumstances.
Life insurance policies that build cash value, such as whole life or universal life, are more expensive than term insurance policies because part of that additional cost goes into growing cash value. Accumulating cash value takes time, but before making a decision on cash value life insurance, there are some important things to understand.
What Is Cash Value?
Cash value is a portion of your policy’s death benefit that has become liquid. It grows at different rates for different insurers. This is referred to as the rate of accumulation, or the ROA. Universal life policies offer different options for how excess premium is invested, which result in different rates of return.
The risk in borrowing against your cash value is that it comes out of your death benefit. This means that if you borrow against it and die while the loan is outstanding, the death benefit is reduced by the amount of the outstanding loan. So, before you borrow against your accumulated cash value, one question you should ask yourself is if you die the day after you borrow the money, will there be enough death benefit left to fulfill your reason for buying the insurance in the first place?
How Does Cash Value Life Insurance Work?
Cash value life insurance accumulates value in a separate account within the policy. Whenever a premium is paid, part of the money goes for the cost of the insurance, which is the amount of money necessary to provide the policy’s death benefit.
Additionally, there are fees and overhead which are the costs of the insurance company to provide the coverage. Cash value is actually an account within the life insurance policy separate from the death benefit.
A beneficiary receives the death benefit but does not receive the cash value in the policy. Any cash value that remains in the life insurance policy when you die is kept by the insurer.
The cash value of a life insurance policy is the amount of money you would receive by surrendering the policy. The cash value serves as an investment that accumulates tax-deferred interest.
Types of Cash Value Life Insurance Policies
Unlike term life insurance, cash value life insurance policies are permanent and will last for the remainder of your life as long as the premiums are paid. Among the typical types of cash value life insurance policies are:
- Whole Life Insurance – This builds cash value at a fixed rate decided by the insurer. It will reach the amount of the death benefit when the policy matures.
- Universal Life Insurance – This type of policy is based on market interest rates and how the insurer performs financially.
- Indexed Universal Life Insurance – This type of policy is based on the performance of an index like the S&P 500.
- Variable Life Insurance – This type of policy is similar to a mutual find in that the insurer offers different options for investing cash value.
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It’s Not Free Money!
A very common misconception about borrowing money from life insurance cash value is that it is free money, a no-strings, no-expense deal. This is not true.
Life insurance companies are in business to make money, and when you withdraw cash value from a policy, the insurance company no longer has that money available to invest, cover overhead or pay other beneficiaries’ claims, and so they charge interest to make up the difference.
Unlike a bank loan, you are not obligated to pay back a loan against your cash value. The risk is that the loan never gets paid back. Interest on borrowed cash value will continue to accrue and eat away at your death benefit, further reducing what will be there for your loved ones when you are gone.
Borrowing from the cash value of your life insurance does have some upsides, the biggest of which is the tax advantage. Withdrawals of any amount from the accumulated cash value of your whole or universal life policy are tax-free, up to the amount of the premiums you have paid. As a rule, “withdrawals” generally include loans.
This tax-free status is a lifetime benefit, which means that it will continue to be untaxed as long as you live, even if you do not repay it. However, the tax-free status ends with your death; any outstanding balance at that time is taxable. It is always advisable to check with an accountant before moving forward. Tax laws and regulations are always changing and it is better to be on the safe side.
It Won’t Be There When You Need It
Removing cash value from your life insurance policy may leave you vulnerable to life’s uncertainties. The whole point of life insurance is to provide some financial stability for your loved ones if you die unexpectedly. If you borrow too much against your policy, it could hurt this goal.
However, one advantage of cash value beyond loans is that it can be used to pay premiums, and therefore keep your insurance in place when you’re unable to manage payments due to difficult financial circumstances.
When Is a Good Time to Borrow?
There are times when conventional loans or credit are just not an option, such as when your credit is poor. If your only alternatives are high-interest credit card advances, payday loans or high-interest personal loans, your life insurance policy may be your best option. Bear in mind that a conventional loan is often a better choice in the long run, especially if you can get at a low interest rate loan.
Borrowing against your cash value also makes perfect sense if you have a high cash value and are presented with an investment opportunity that generates a higher return than the interest on your loan. Of course, there really is no such thing as a risk-free investment; you should carefully weigh the risks and possible rewards before withdrawing funds.
Other Ways to Get Money Out
Loans are not the only way to access the accumulated cash value of your whole or universal life policy – they’re just the most common.
Many insurers pay an annual dividend to policyholders. Insurance dividends are usually the money that is left over from all the premiums collected after overhead expenses and claims are paid. They are non-taxable because the IRS considers them a return of premium rather than a traditional dividend; so, they are a great way to get some extra money out of your life insurance.
Another option is called surrender value. Generally speaking, after a policy has been in force for at least three years and has accumulated some cash value, you can cancel the policy and take the surrender value in a cash payment. In the early years of a policy there are usually fees involved that will reduce the cash value.
Finally, one other option is a life settlement, in which the policy is sold to a third party for a cash sale.
The more important thing to remember is that surrender means giving up the insurance. You get the cash value, less any fees, and the insurance is terminated. Unlike a loan, there is no interest or repayment – but there is also no death benefit. Consider surrender only as a last resort or if you have adequate life insurance in place elsewhere.
One of the reasons you decided to buy a whole or universal life policy was because it builds cash value and you have the ability to borrow against it. The other reason, and perhaps the more important one, was to make provisions for those left behind after your death.