Policy loans are a unique financial tool that allow policyholders to borrow against the cash value of their permanent life insurance policies. While this option offers quick and easy access to funds, it’s important to understand exactly how these loans are calculated to make informed decisions about borrowing. Whether you’re a policyholder considering a policy loan, a financial advisor guiding a client, or an insurance professional, this guide breaks down everything you need to know about the calculation process.
What Is a Policy Loan?
Before discussing how policy loans are calculated, it’s important to understand what they are. A policy loan allows you to borrow money from the cash value of your permanent life insurance policy. The cash value serves as collateral for the loan, and the amount you can borrow depends on the total cash value accumulated over time.
Key characteristics of a policy loan include:
- No approval process, as you’re borrowing against your own assets.
- No strict repayment schedule. However, unpaid interest or principal may reduce your death benefit.
- No taxation, as long as the policy stays in force.
How Are Policy Loans Calculated?
The amount you can borrow and the terms of your policy loan are determined by your insurer. Below are the key factors and steps involved in calculating a policy loan:
1. Cash Value Accumulation
The first step in calculating a policy loan is determining the total cash value of your permanent life insurance policy. Cash value is the investment component of your policy, which grows over time through premium payments and investment returns (depending on the type of permanent policy you have).
- Policies typically start accumulating cash value after a set period (e.g., 10 years).
- Only permanent life insurance policies, such as whole life or universal life insurance, accumulate cash value. Term life insurance policies do not.
2. Borrowable Percentage
Most insurers allow policyholders to borrow a percentage of the total cash value, often up to 90%, but this percentage varies by company. For example, if your policy has a cash value of $50,000 and your insurer allows borrowing up to 90%, you could borrow $45,000.
3. Interest Rates
Borrowed funds accrue interest, which can either be fixed or variable depending on your policy terms. Interest is an additional cost you’ll be responsible for, whether you make payments or choose not to repay the loan at all. Unpaid interest will continue to accrue and can eventually eat into your death benefit.
4. Outstanding Loan Impact on Death Benefit
If you don’t repay the loan, the outstanding balance and accrued interest will reduce the policy’s death benefit. For example, if you have a loan balance of $10,000 when you pass away, your beneficiaries will receive the policy’s death benefit minus the $10,000 owed.
5. Policy Lapse Risks
If the total loan amount (including accrued interest) exceeds the cash value of the policy, the policy may lapse, resulting in its termination. If this happens, the loan balance may be considered taxable income by the IRS.
6. Loan Repayment Options
Policyholders have flexible repayment options. They can:
- Make periodic payments of principal and interest. This ensures the death benefit remains intact.
- Pay annual interest only, with no immediate obligation to repay the principal amount.
- Allow the loan and its interest to accrue, deducting these amounts from the policy’s death benefit.
It’s important to note that failing to manage the loan properly could lead to reduced benefits for beneficiaries or potential tax implications.
An Example Calculation:
Here’s an example to illustrate how a policy loan is calculated:
- Cash Value of Policy: $100,000
- Maximum Borrowable Percentage: 90%
- Interest Rate: 6% annually
If you decide to borrow the maximum, you would get up to $90,000. After one year, the interest owed would amount to $5,400 ($90,000 x 6%). If unpaid, this interest would be added to the loan balance, bringing it up to $95,400.
Why Policy Loans Are Attractive
Policy loans are a popular borrowing option for a reason. Here are some advantages:
- Quick and Accessible: You avoid the lengthy approval process required for personal loans or lines of credit.
- Flexible Use: Funds can be used for anything, from paying off debts to funding a business or emergency expenses.
- No Tax Implications (as long as the policy remains in force): Unlike withdrawals, loans are not considered taxable income.
- No Repayment Obligations (if you’re comfortable with reducing the death benefit): You can leave the loan unpaid during your lifetime.
Risks of Policy Loans
Despite their benefits, policy loans come with risks that every borrower should know.
- Reduced Death Benefit
The loan balance and any accrued interest will reduce the amount paid to your beneficiaries upon your death.
- Policy Lapse
If the loan amount surpasses your policy’s cash value, it could trigger a lapse, leaving you without coverage and with a potential tax bill.
- Interest Accumulation
While loan interest rates are usually lower than personal loans, they can still accrue quickly if left unpaid.
Key Takeaways
Policy loans can provide financial relief and flexibility, but they require proper management to avoid risks. To sum up how policy loans are calculated:
- They depend on your policy’s cash value and the borrowable percentage (typically up to 90%).
- The insurer determines loan terms, including interest rates and eligibility requirements.
- If unpaid, policy loans reduce the death benefit and risk causing the policy to lapse.
Final Thoughts
Understanding how policy loans are calculated empowers you to make the best possible decisions for your financial situation. If you’re considering a policy loan, consult with a financial advisor or insurance professional to understand how it fits into your overall financial strategy.
Policy loans offer significant benefits when used wisely. Be sure to weigh the pros and cons and manage your loan responsibly to maximize its advantages!
