Permanent Life Insurance Policies will accumulate a cash value and this money can be borrowed to meet emergency needs. This can be a real benefit of Life Insurance or it can have serious consequences.
The primary purpose of Life Insurance is to provide financial security to your dependents in the event of your death. In recent years, Life Insurance has developed several secondary purposes such as savings, investment, and tax deferment vehicles. Permanent Life Insurance Policies gain a cash value as time goes on and loans can be made against this cash value. The cash value in the policy is not actually what is given to you when you borrow against it. It still remains in your account and your Life Insurance remains in force.
The cash value actually acts as security against the loan. This seems like a good thing. You get the money and your coverage remains intact. In many cases the repayment provisions are very liberal. It is really the interest on the loan that must be repaid annually. The repayment of the loan itself can often be put off until a later date and then repaid in a manner that does not strain your financial resources unduly. All in all, it looks like a pretty good deal.
It is a good deal, but there are some pitfalls. In most cases, the full loan will be deducted from your death benefit should you happen to die before the loan is repaid. This may result in your beneficies receiving much less than you planned on them getting and maybe less than their actual needs. Also, should you be able to pay the annual interest, it is added to the loan balance. This increases the interest during the next period and further reduces the death benefit.
Some policies are structured so that earnings are used to pay premiums. It is possible that the loan and interest might so decrease earnings that they will be insufficient to cover the premiums. This will mean that you will have to pay them out of pocket at a time when you are trying to avoid extra expenses. If for any reason, you should be able to repay the loan resulting in a lapse of your policy, you not only lose your coverage, but are subject to tax on any deferred income.
These pitfalls do not necessarily mean that Life Insurance Policy loans are a bad idea. They can serve a valuable purpose during times when extra capital is needed such as paying for college tuition or funding a retirement account. The secret is to make sure you understand the consequences of the loan and all of the provisions. Your Insurance Agent can provide a Policy Illustration that will detail the impact of the loan on your death benefit.