17 Aug Risks of borrowing from an insurance policy

 Q. I have a $45,000 cash value in a life insurance policy, but the investments don’t make much money. Should I take a loan from that and invest on my own? What are the disadvantages?

A. Generally speaking, no. It often doesn’t make sense to borrow against a life insurance policy.

Borrowing against the policy has too many potential pitfalls and not enough advantages, said Howard Hook, a certified financial planner and certified public accountant with EKS Associates in Princeton.

“Dying with the loan against the policy reduces the death benefit to your beneficiaries who may need the money,” he said.

And what if the investments you make do not perform well? Hook said investments generate taxable income while proceeds from life insurance policies typically are tax-free to beneficiaries.

Then what happens if you are unable to make interest payments on the loan or if you accidentally do not make all the interest payments?

“The cash value will be used to make those payments but at some point may not be sufficient to support the face value of the policy,” Hook said. “Many times policy premiums are calculated assuming certain growth of the cash value which incurring a loan may alter.”

Peter McKenna, a certified financial planner with Highland Financial in Riverdale, also said borrowing against the policy often doesn’t make sense.

You’d lower the amount that your survivors would receive upon your demise, so if that’s why you have the insurance, you will have compromised your plan.

He said most insurance companies charge relatively high interest rates for the borrowing and this creates a high hurdle rate that the other investments would have to beat in order for this to be an economically valuable endeavor.

“One of the old adages, `buy term insurance and invest the savings,’ would be my initial reaction to your question, but make sure you have any required insurance in place before you cancel the current policy,” McKenna said.

Start by evaluating how much life insurance, if any, you need. Life insurance is best used to provide financial support to those that rely on you financially should something happen to you, he said.

“If you determine that there is a need for life insurance, you need to quantify how much is needed and for how long,” McKenna said. “Some people will want enough to pay off all liabilities, education expenses and provide an amount of money to be invested to provide an income to your financial dependents.”

To get a ballpark figure, he said you can use a conservative estimate that the survivor can withdraw 4 percent per year. So if the survivor will need $40,000 per year above any other income sources, assume you should have $1 million dollars of life insurance for income and additional amounts to pay off debts and education, McKenna said.

Then, the timeframe will depend on your circumstances.

If you have young children, a 20-year year term policy may be appropriate. If they are teenagers, maybe five or 10 years is enough, he said.

“In today’s environment few people need permanent — i.e. cash value — life insurance, but if you are a business owner or have another specific reason to need permanent insurance, it may be worth pricing a new permanent policy,” he said.

If you are in reasonably good health you may be surprised at how inexpensive it is to obtain the right insurance for your needs, McKenna said. Over the past few years, life expectancies have been rising quickly and insurance companies are charging less as they expect fewer payouts due to premature deaths.

“Even polices that were written as little as five years ago may be worth re-pricing if you are in similar health to when it was written,” he said.

McKenna said it’s likely that you can obtain a similar amount of coverage for the time needed at a lower annual cost than the current policy, and once that policy is in place, you can cash in your old policy.

“The end result is that you would then have the cash value to invest upfront and the annual savings on the premium can be added to the investment account,” he said. “Alternatively, you may realize that you need more insurance than this policy provides and the savings from changing from a permanent policy to a term policy will help to offset the cost of the additional coverage that is needed.”

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This story was first posted in August 2015.