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Policy loans can provide cash in a pinch, but can impact your insurance portfolio. Here’s what you need to know before applying for one.When a sudden need for cash arises, most of us know to turn to banks for a personal loan. However, did you know that there is another source – other than banks, pawnshops or licensed moneylenders – from which you can borrow the money you need? And that depending on circumstances, may not even need to pay the money back? Relax, we’re not suggesting anything nefarious or illegal. What we are referring to are policy loans, which are only available on certain types of insurance policies. In practice, taking a policy loan looks a lot like borrowing money from yourself. However, what actually happens is that you pledge your insurance policy as collateral in order to obtain a sum of cash. But what is the collateral that is being used for the loan? What happens if you do not pay back the loan? And since you’re essentially borrowing money from yourself, do you even need to pay it back? What is a policy loan and how does it work?A policy loan is a type of loan that is issued by an insurance company. It utilises the cash value of the insurance policy as collateral for the loan. This means that in order to obtain a policy loan, you first need to be a policyholder. And because the collateral used is the cash value of the policy, only insurance policies that have a cash value can offer a policy loan. You may also need to wait till your policy generates sufficient cash value before applying for a policy loan capable of meeting your needs. Q1: Are policy loans available on all insurance plans? These include most whole life policies, as well as endowment and annuity plans. See the table below for a (non-exhaustive) summary.
Q2: How will taking a policy loan impact your insurance plan? Secondly, interest will be charged on your policy loan, which can be steep. You need to pay attention here because if the added interest causes the total loan value to outstrip the cash value of your insurance plan, it will likely lapse, leaving you with no protection. Thirdly, taking a policy loan does not cause your insurance plan to terminate, as it is not the same as surrendering your policy. Hence you’ll need to continue paying your premiums in order to keep your policy in force. Q3: Do you need to repay your policy loan? As such, policy loans do not have a stipulated loan repayment date, leaving it up to your own discretion on how to manage the loan. Q4: Should you repay your policy loan? However, at the very least, you should cover the interest charges on the policy loan to prevent the loan amount from growing larger than the cash value, in order to avoid premature termination of your plan. On the other hand, if you are sure you do not want the policy any longer, consider surrendering it so you can wrap things up neatly. The surrender value may be higher than what the policy loan provides. Ultimately, whether to repay your policy loan or not is a question of balancing between present and future needs. *Regular paying investment linked plans (ILP) has a feature that is similar to an ‘automatic premium loan’. When premiums are not paid, the units of investment are deducted to keep the policy in force. Once the cash value or units are fully deducted, the policy will lapse. When should you take a policy loan?Now that you understand how policy loans work, you may be wondering if you should apply for one, instead of going for, say, a bank loan. To help answer that question, let’s compare the two.
From the table above, we can see that we should use a policy loan when we:
Conversely, we should go for a bank loan when we:
Read these next: What interest rate is charged on policy loans?Payback options include periodic payments of principal with annual payments of interest, paying annual interest only, or deducting interest from the cash value. Interest rates can be as high as 7% or 8%.
Why is there interest on life insurance?Premium Payments are Divvied Up
The rest of the premium payment will go toward your policy's cash value. The life insurance company generally invests this money in a conservative-yield investment. As you continue to pay premiums on the policy and earn more interest, the cash value grows over the years.
Do you have to pay back a policy loan?Repayment of a life insurance loan is not required, but it's typically in your interest to do so because the outstanding loan amount detracts from the death benefit. Also, as loan interest compounds over time, the total balance may grow larger than your cash value, causing the policy to lapse.
What action will an insurer take if an interest payment on a policy loan?What action will an insurer take if an interest payment on a policy loan is not made on time? Unpaid interest from a policy loan is added to the loan balance if not paid by the due date.
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