A Life insurance policy loan is an often referenced aspect to cash value life insurance. Most agents will bring the topic up casually, and I'd suggest far too casually. Some may discuss only because of their lack of complete understanding, while others have become too comfortable with the topic and have resorted to throwing about industry vernacular without regard to the nuance it poses to the general consumer…I apologize for all the times I have done this and will do this in the future.
We wanted to take a step back and spend some time discussing life insurance policy loans because it's a topic we've found to be quite alluring to many people, yet general knowledge is quite scant. Policy loans are an often referenced solution by us and many other agents, without a whole life of explanation for why or even what's going on. We hope that today the “mysteririty” of policy loans will come to an end.
First, Let's Address an Obvious Question
I want to start by pointing out something a policy loan is not. It is not a means for insurance agents to supplement their income or pad their wallets. There's no compensatory incentive for an agent to recommend a policy loan. Policy loans have no set fees, and the interest collected goes straight to the insurance company, nothing goes to the agent. We are, however, aware of rare agent contracts that may place a financial disincentive on the agent regarding outstanding policy loans. That however is a topic for another day. Simply understand that agents do not talk about policy loans because there is money to be made, it's merely a benefit at the policy holders disposal.
Other things Policy Loans are Not
While we're at it, it makes sense to address a few other items that are not true of policy loans, to further identify what they are, and even highlight some of their benefits.
Policy loans are not your money. When one takes a policy loan, the money they receive comes directly from the insurance company, the cash value inside their policy stays put. We're going to come back to this point later on.
Your Only Option
Policy loans are not your only option to access cash values inside your policy. While it's true that the only way to access guaranteed cash value inside a whole life policy is through a policy loan. It is not true that one must take a policy loan in order to access non-guaranteed values (i.e. those that are created through paid-up additions) and it's also not required to access any of the cash value inside a universal life insurance policy if any derivative (in fact, surrenders for all forms of cash value was one of the original stated benefits of universal life insurance).
What it is/How it Works
Now that we know what policy loans are not, let's dive into the mechanics of what they actually are and can do.
A policy loan is a loan floated by the insurance company to the policy holder. The loan is a guaranteed provision stipulated in the policy holder's contract. Within the contract, the loan is detailed in terms of:
- When loans are available
- How interest is charged on the loan
- How the maximum loan amount is calculated (also known as the loan value)
- The minimum loan amount that can be made
Some insurance companies allows policy loans as soon as the policy has cash surrender value, while others require that the insured wait until the policy has reached its first policy anniversary before making loans available. Technically Standard Non-Forfeiture Law does not require an insurance company to make cash surrender values available until after the policy has reached it's second anniversary date, but it's very rare to see a company use this benefit offered to them. To be clear, this is not an option an insurance company can choose to change, it's contractually stipulated from the outset.
How Interest is Charged
The points here are when interest is charged (in arrears or in advance) and how it's charged. Some companies stipulate a fixed rate of interest, while others use a variable interest rate. Companies that use a variable rate generally tie it to a a bond index (usually the Moody's Corporate Bond Index).
The Loan Value
Loan value is the technical term used for maximum loan available. The contract will stipulate the way in which this is calculated, but most often, it's just an exercise in how excruciatingly detailed someone can explain cash value plus dividends for the year.
The minimum loan is generally a few hundred dollars. And this exact amount is generally stipulated in the contract. If there is no stipulation, than it can be assumed there is no set contractual minimum, thought the company may have procedural norms for issuing loans that means as a rule they wont issue loans for less than $100 or $200 dollars.
No Credit Worthiness Required
Most contract will note that the only source of funds used to secure a loan against a life insurance policy is its loan value (i.e. cash value life insurance essentially).
Insurance companies do not require any sort of credit check to issue a policy loan, nor is there generally any waiting period (most companies will include contractual language that notes they can take up to 6 months to issue a loan but this is merely a measure to protect against significant financial disintermediation and has never been used in any ubiquitous fashion within the industry).
The cash surrender value in the policy is pledged as collateral for the loan, so if the policy holder surrenders the policy, the loan will be retired by the cash surrender value first, before any additional proceeds are paid to the policy holder. If the policy/insured should die with an outstanding loan on the policy, the loan is merely repaid and then the remaining death benefit is paid to the beneficiary(ies).
Your Money Stays Put
I mentioned already that when one uses a life insurance policy loan, the money comes from the insurance company while the cash value in the policy remains in the policy. This is feature of substantial importance when it comes to the many benefits of owning cash value life insurance. This is also the aspect that gets much of LEAP, Bank on Yourself/Infinite Banking, and many other similar ideas off the ground. I've talked before about how this works with whole life dividends; now we should take a second or two to discuss is concerning policy loans.
Because the cash value is not removed from the policy–like it would be if you were to take a surrender. The money continues to earn guaranteed interest and dividends or non-guaranteed interest if the universal life contract has a provision to not lower the interest rate.
So in other words. All you do is ask the insurance company to lend you some money, and they'll do that up to the amount of cash surrender value that you have. Meanwhile your cash value remains in your policy and continues to do what's been doing from the beginning, make you money. You take the money out of a drive around town, and can put it back when you're done.
Doesn't have to be put back, though. It's also true that we use loans for income generation with no intention to ever repay the loan. Want to know more? Give us a shout.
Don't Let the Name Scare or Fool You
The word loan sometimes frightens people, while others interpret the word loan for manipulative reasons to decry the use of cash value life insurance. Don't be scared off or fooled by slick counter sales tactic.
There are several benefits to policy loans that warrant a strong look. Perhaps a future article on the Insurance Pro Blog is in order to highlight these benefits (maybe several articles actually).
A life insurance policy loan can be very beneficial to you and any plan that incorporates cash value life insurance as an asset in their portfolio.