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Cash value life insurance policies are a little bit like luxury
cars, says John A. Kiczek, analyst in the life and health division of
A.M. Best Co., an Oldwick, N.J., insurance information services firm.
You can get a bare-bones policy relatively cheaply, or you can load your policy up with bells and whistles ranging from premium waivers to double-indemnity clauses that promise to pay twice the normal death benefit if the insured person dies in an accident.
What may be the most widely offered and least understood of these policy options, however, is the ability to borrow against the cash value accumulated in your account. Although the vast majority of insurers offer this benefit, many consumers don't fully understand how these loans work until after they've taken one out.
What's hard to understand? For one thing, when you take out the loan, there's no set repayment schedule. In fact, you don't necessarily need to pay the loan back at all. But the loan will affect the death benefit on the policy. And the interest rate may be higher than you think. Some policy loans are a tremendous bargain and others come at a tremendous cost.
Before you take out a loan, you need to find out the facts. What do you need to know? Here is a question-and-answer look:
Q: How much can I borrow from my insurance policy?
A: In most cases, you can borrow an amount equivalent to the full cash value accumulated in your account. If, for example, you have a $100,000 policy with a $50,000 accumulated cash value, you could borrow as much as $50,000.
Q: How do I get the loan? And how long will it take?
A: Usually all you need to do is call your insurance agent. It can take up to two weeks to process the check, but in an emergency, a loan can sometimes be processed in as little as three days, says Ben Baldwin, president of Baldwin Financial Services in Northbrook, Ill., and author of several books on life insurance.
Q: What's the interest rate?
A: That's the $64,000 question. There is always a stated rate of interest, but frequently there will be hidden costs that can boost the effective interest rate.
For instance, in today's market, the annual interest rate on a loan from a whole life policy might run about 7%. However, the dividend you earn on the cash value of your account might also be affected. How severely? There's no way to know in advance, says Baldwin.
But be aware that many companies reduce the dividends they credit to your account when you've borrowed against it for as long as you have the loan. That reduction, then, boosts the real cost of your loan.
Q: Do all companies do that?
A: Not all, but it is fairly common for those that allow loans at a fixed rate of interest. It's simply because there is no set payoff date for your loan. If interest rates rose in the future, the insurer would find itself forced to pay you more on the accumulated cash value in your account than you were paying on the loan, so the insurer would be taking a loss on the deal.
It is important to note that you are not withdrawing money from your account when you borrow from a whole life policy. You are getting a loan from the insurance company, which is holding your policy as collateral.
Q: How can I know ahead of time if the company will reduce my dividend if I borrow against my policy?
A: Your agent should alert you to the practice in advance. In any case, you should be sure to ask before you take out a loan. And pay attention to the amount of interest you are being credited on the cash portion of your account both before and after the loan is funded, to get an idea of the effect the loan will have on the rate of return you earn on your policy. If the impact will be severe, you may want to pay off the loan quickly--and turn to a different source of funds should you need to borrow money again.
Q: Is that the way it works on all types of cash value policies? Or is there a difference in how loans are handled with a whole life policy compared with a universal life policy?
A: Great question. The example above involves a whole life policy. If you have a universal life policy, it would be more likely to work as follows, Baldwin says: You have $50,000 in the invested portion of your account. You want to borrow $10,000. The insurer takes $10,000 out of the policy's investment account, where it might be earning, say, 6% annually, and puts it into a "guaranteed" fund, where the money earns just 4.5% a year. You then borrow $10,000 from the insurance company at a 5.5% rate of interest.
Does that mean you're paying just 5.5% to borrow that money? No. Because the return on the guaranteed account is 1.5 percentage points lower than the return on the investment account where it had previously been invested--and because moving it into the 4.5% guaranteed fund is required, not voluntary--your true interest rate on the loan is closer to 7%--the 5.5% you are charged plus the 1.5% "opportunity cost."
Q: What do you mean when you say the loan doesn't necessarily need to be paid back?
A: Just that. In most cases, an insurer will let you keep the loan outstanding for as long as your policy is in force. You won't even be required to make any kind of monthly payment on it. Generally speaking, you can opt to pay as much or as little as you like, Baldwin says.
But here's the rub. If you don't pay at least enough to cover the interest payments, the amount in unpaid interest will accrue and be added to the loan balance. As that balance rises, the interest you owe rises with it. If the loan balance goes high enough, it will eat up the cash value in your account, which could cause your policy to lapse.
Q: Can I pay the loan interest with the accumulated dividends or interest that are building up in my account?
A: Yes. And this can be an effective way to go, because it allows you to use pretax dollars--investment income earned in an insurance policy is not taxed until the money is withdrawn from the policy. But again, you need to be sure you are paying at least enough to cover the interest or your loan amount will rise.
Q: How does a loan affect the death benefit?
A: If you die while you have a loan outstanding, the death benefit will be reduced by the amount of the loan and any unpaid interest.
* * * Adapted from "Kathy Kristof's Complete Book of Dollars and Sense." Printed with permission of Macmillan Publishing, New York. Write to the author in care of Personal Finance, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053, or kathy.kristof@latimes.com. KATHY M. KRISTOF welcomes comments and suggestions for columns but regrets that she cannot respond individually to letters and phone calls.
You can get a bare-bones policy relatively cheaply, or you can load your policy up with bells and whistles ranging from premium waivers to double-indemnity clauses that promise to pay twice the normal death benefit if the insured person dies in an accident.
What may be the most widely offered and least understood of these policy options, however, is the ability to borrow against the cash value accumulated in your account. Although the vast majority of insurers offer this benefit, many consumers don't fully understand how these loans work until after they've taken one out.
What's hard to understand? For one thing, when you take out the loan, there's no set repayment schedule. In fact, you don't necessarily need to pay the loan back at all. But the loan will affect the death benefit on the policy. And the interest rate may be higher than you think. Some policy loans are a tremendous bargain and others come at a tremendous cost.
Before you take out a loan, you need to find out the facts. What do you need to know? Here is a question-and-answer look:
Q: How much can I borrow from my insurance policy?
A: In most cases, you can borrow an amount equivalent to the full cash value accumulated in your account. If, for example, you have a $100,000 policy with a $50,000 accumulated cash value, you could borrow as much as $50,000.
Q: How do I get the loan? And how long will it take?
A: Usually all you need to do is call your insurance agent. It can take up to two weeks to process the check, but in an emergency, a loan can sometimes be processed in as little as three days, says Ben Baldwin, president of Baldwin Financial Services in Northbrook, Ill., and author of several books on life insurance.
Q: What's the interest rate?
A: That's the $64,000 question. There is always a stated rate of interest, but frequently there will be hidden costs that can boost the effective interest rate.
For instance, in today's market, the annual interest rate on a loan from a whole life policy might run about 7%. However, the dividend you earn on the cash value of your account might also be affected. How severely? There's no way to know in advance, says Baldwin.
But be aware that many companies reduce the dividends they credit to your account when you've borrowed against it for as long as you have the loan. That reduction, then, boosts the real cost of your loan.
Q: Do all companies do that?
A: Not all, but it is fairly common for those that allow loans at a fixed rate of interest. It's simply because there is no set payoff date for your loan. If interest rates rose in the future, the insurer would find itself forced to pay you more on the accumulated cash value in your account than you were paying on the loan, so the insurer would be taking a loss on the deal.
It is important to note that you are not withdrawing money from your account when you borrow from a whole life policy. You are getting a loan from the insurance company, which is holding your policy as collateral.
Q: How can I know ahead of time if the company will reduce my dividend if I borrow against my policy?
A: Your agent should alert you to the practice in advance. In any case, you should be sure to ask before you take out a loan. And pay attention to the amount of interest you are being credited on the cash portion of your account both before and after the loan is funded, to get an idea of the effect the loan will have on the rate of return you earn on your policy. If the impact will be severe, you may want to pay off the loan quickly--and turn to a different source of funds should you need to borrow money again.
Q: Is that the way it works on all types of cash value policies? Or is there a difference in how loans are handled with a whole life policy compared with a universal life policy?
A: Great question. The example above involves a whole life policy. If you have a universal life policy, it would be more likely to work as follows, Baldwin says: You have $50,000 in the invested portion of your account. You want to borrow $10,000. The insurer takes $10,000 out of the policy's investment account, where it might be earning, say, 6% annually, and puts it into a "guaranteed" fund, where the money earns just 4.5% a year. You then borrow $10,000 from the insurance company at a 5.5% rate of interest.
Does that mean you're paying just 5.5% to borrow that money? No. Because the return on the guaranteed account is 1.5 percentage points lower than the return on the investment account where it had previously been invested--and because moving it into the 4.5% guaranteed fund is required, not voluntary--your true interest rate on the loan is closer to 7%--the 5.5% you are charged plus the 1.5% "opportunity cost."
Q: What do you mean when you say the loan doesn't necessarily need to be paid back?
A: Just that. In most cases, an insurer will let you keep the loan outstanding for as long as your policy is in force. You won't even be required to make any kind of monthly payment on it. Generally speaking, you can opt to pay as much or as little as you like, Baldwin says.
But here's the rub. If you don't pay at least enough to cover the interest payments, the amount in unpaid interest will accrue and be added to the loan balance. As that balance rises, the interest you owe rises with it. If the loan balance goes high enough, it will eat up the cash value in your account, which could cause your policy to lapse.
Q: Can I pay the loan interest with the accumulated dividends or interest that are building up in my account?
A: Yes. And this can be an effective way to go, because it allows you to use pretax dollars--investment income earned in an insurance policy is not taxed until the money is withdrawn from the policy. But again, you need to be sure you are paying at least enough to cover the interest or your loan amount will rise.
Q: How does a loan affect the death benefit?
A: If you die while you have a loan outstanding, the death benefit will be reduced by the amount of the loan and any unpaid interest.
* * * Adapted from "Kathy Kristof's Complete Book of Dollars and Sense." Printed with permission of Macmillan Publishing, New York. Write to the author in care of Personal Finance, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053, or kathy.kristof@latimes.com. KATHY M. KRISTOF welcomes comments and suggestions for columns but regrets that she cannot respond individually to letters and phone calls.
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