10 Jul Using life insurance to pay medical bills

Q. I have some credit card debt from medical bills and I really want to pay it off. I could take money from the cash value of my life insurance, otherwise I just have to pay it as I go. Are there downsides to using the cash value?
—Working it out

A. Cash value from your life insurance policy can come in handy when you’re short on cash, but there’s a lot to consider.

Without knowing more about your overall financial situation, such as your age, the amount of your medical bills, details of your insurance policy, and more, we can’t give you a definitive answer. But let’s talk about the general issue.

It’s certainly a good idea to try to eliminate the credit card debt, especially given the 16 percent average interest rate charged on credit cards.

The question then becomes whether you can refinance and pay off the credit card debt using a lower-interest loan or cash from another source, such as your life insurance policy, said Gene McGovern of McGovern Financial Advisors in Westfield.

He said policies that have a cash value, such as whole life or universal life, allow you to borrow against the cash value or even to withdraw money from the cash value. But taking money from your cash value carries risks and downsides, he said.

Assuming that you want to keep the policy in force and that the policy has enough cash value to pay off the medical bills, there are two basic ways you can access the cash value: withdraw money from it or take out a loan against it.

“You generally can withdraw amounts from a policy’s cash value that you’ve previously paid in premiums — known as the policy’s basis — tax-free,” McGovern said. “If you take out more than you’ve paid in premiums, the excess is taxable income.”

The bigger drawback, he said, is that the death benefit of the policy will be reduced dollar-for-dollar by the amount you withdraw.

Alternatively, you could take out a loan by borrowing against the cash value. What this means is that you are taking out a personal loan from your life insurance company that uses the policy’s cash value as collateral, McGovern said. And unlike other types of loans, a policy loan doesn’t have to be paid back.

“The interest rate on the loan from your life insurance company will be less than you’re paying on the credit card because the cash value serves as collateral for the loan,” he said. “Moreover, the cash value remains invested at your insurance company, although sometimes at a reduced interest rate, so the net borrowing cost is even less.”

So if the interest rate on the policy loan is less than you’re paying for the credit card debt, this may make economic sense, McGovern said.

You still need to consider the potential downsides of borrowing against the cash value.

Just as with a cash withdrawal, a loan against the cash value of your life insurance reduces the policy’s death benefit dollar-for-dollar, McGovern said.

“That reduction includes the entire outstanding balance of the loan, including any accrued but unpaid interest,” he said. “So if you die with a loan outstanding, the beneficiaries of your life insurance policy may not receive the death benefit protection that was the reason for taking out the policy in the first place.”

Plus, he said, the very thing that makes taking out a loan against the cash value attractive — a low net interest cost and not having to repay the loan — can also be dangerous because the interest that’s accruing on the unpaid loan — unless you’re paying it back — is compounding, further reducing the death benefit.

McGovern said if the amount of the outstanding loan plus the accrued interest continues to grow, it could potentially cause the life insurance policy to lapse. And you could be required to pay taxes upon the lapse of the policy.

Finally, an outstanding loan can reduce any dividends you may have been receiving from the policy.

So before you dig into your life insurance policy, see if you can pay off the credit card balance using a lower-interest loan from other another source, such as a home equity line of credit or a personal loan.

“If you decide to borrow against the cash value, first ask your insurance agent for an in-force illustration, which should show you how the loan will affect your policy,” McGovern said. “And make sure to repay the loan, so that it doesn’t permanently diminish the policy’s death benefit or cause other unforeseen problems.”

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This post was first published in July 2017.