Published Thursday, June 5, 2014 at: 7:00 AM EDT
William Shakespeare famously wrote in "Hamlet," one of his classic tragedies, "Neither a borrower nor a lender be." But sometimes borrowing can't be helped. You may need cash in a hurry and have few other affordable options. In that case, you might consider borrowing funds from a somewhat unusual source: your life insurance policy.
Compared with taking a traditional bank loan, borrowing against a life insurance policy may offer several potential advantages. But this approach, as Shakespeare probably would have cautioned, is not without its perils.
Life insurance has an obvious primary purpose. But if you opt for whole life insurance, variable life insurance, or universal life insurance—varieties of what often is known as permanent life insurance—as opposed to choosing a term policy, part of your premium payments will build cash value in the policy, and you can borrow against that value. You might need money to help pay an emergency medical expense, buy a home, or even send a child to college. Once your financial situation improves, you can pay back the loan.
There tend to be few restrictions on life policy loans. Although you're not permitted to borrow more than the cash balance of the insurance, you're free to use the funds any way you wish, no questions asked. But there is one significant drawback: When you borrow against your life insurance, you're reducing the benefit that would be paid to your beneficiaries if you die before the loan is paid off.
Compared with other loan sources, your life insurance may offer several advantages:
Because the money you get is a loan, it's not considered income for tax purposes, and if you invest the cash, you may be able to deduct your interest expenses to offset investment income. However, the interest you pay on money you use for personal expenses—for example, to buy a car you don't use for business travel—is not deductible.
There could be additional tax complications if you borrow from a policy that is characterized as a modified endowment contract (MEC), a kind of insurance that may be used to build cash value very quickly. If you take a policy loan from an MEC, the proceeds will be subject to income tax and possible penalties.
A "seven-pay test" determines whether a policy will be treated as an MEC under the tax laws. That test, which limits the total amount you're allowed to pay into your policy during its first seven years, is designed to discourage premium schedules that would result in a paid-up policy before the end of a seven-year period.
Even if a policy isn't classified as an MEC, there may be several potential disadvantages to borrowing against its value. Those could include:
Reduced dividends. By borrowing from the cash value, you limit the amount of dividends that your insurance company may pay to its policyholders.
Increased costs. In some cases, a decrease in cash accumulation in a policy could lead to higher costs for you. That may be especially likely if you borrow against a universal life insurance policy.
Smaller death benefit. Anything you still owe to the policy when you die will be deducted from the amount that is paid to your beneficiaries.
Because it's relatively easy to borrow against life insurance, you may be tempted to take a loan under circumstances that don't really warrant it. Considering all of the potential complications, taking money from your policy could be something to avoid if you can. If you take a policy loan to finance an exotic vacation trip or to buy a luxury car, for example, you could end up shortchanging your family unnecessarily. Before you borrow, get expert advice about how such a loan may affect your taxes, premiums, policy coverage, and dividends. And don't ignore the ultimate impact on your life insurance's original goal of helping your beneficiaries.
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