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3 Options for Borrowing Against a Whole Life Insurance Policy

When clients need advice on borrowing against a whole life policy, your expertise will be critical in guiding them to the right solution.
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3 options for borrowing against a whole life insurance policy

When clients need advice on borrowing against a whole life policy, your expertise will be critical in guiding them to the right solution.

Your client can borrow against a whole life policy directly from the insurer, from a bank or from a third-party broker. Often, policyholders don't know they have such options.

All three loan types use the policy as collateral. If there's a loan balance when the insured dies, the lender uses the death benefit to repay the debt. Beyond those similarities, however, the three loan types have very different rules, risks and financial implications.

To prepare you for leading your clients through this analysis, here's an overview of three ways to borrow against a whole life insurance policy:

1) Insurer-funded loan. Borrowing from the carrier is quick and easy. There's no loan application or approval process. The insurer cuts a check right away and doesn't ask for any repayments.

If the client doesn't make repayments, the accrued interest is added to the loan balance, which raises the interest expense over time. Additionally, with interest rates around 5%-8%, insurer-funded loans already come with the highest interest expense. Because of these factors, at some point, the interest expense may exceed the policy's dividend income.

To keep the loan principal from increasing, the client must also pay the policy premiums—and possibly more if the loan's interest expense ticks higher. If the policy lapses for any reason and the loan balance exceeds the cumulative premiums paid on the policy, the client will receive a 1099 for the difference between the cost basis and the total loan. The result can leave the insured with a massive tax bill, along with a lapsed insurance policy.

The insurer-funded loan is the most common approach. Unfortunately, because of the potential tax liability and higher interest rates, it can also be the most damaging financially.

2) Bank-funded loan. Some banks offer interest-only loans using whole life insurance as collateral. The application process is more involved than borrowing directly from the carrier and your client would need to make interest payments. However, the bank's interest rate is usually lower than an insurer's.

The advantage of making interest payments is that the loan balance won't increase over time. Normally, the client can keep paying the interest indefinitely or optionally repay the principal. Paying off the loan would remove the bank's interest from the insurance and restore the policy's death benefit.

If the policy lapses while a bank loan is outstanding, the bank can demand immediate repayment. This can be financially disastrous. For that reason, a bank loan isn't ideal for the client who's struggling to make premium payments.

3) Broker-funded loan. Your client can also use the whole life policy as collateral for a loan funded through a third-party broker. This loan type blends the advantages of the other two options to create a lower-risk product for your client.

As with an insurer-funded loan, a third-party broker loan can fund quickly, on up to 95% of the policy's cash value. Repayments are optional and the interest accrues to the loan balance over time. The broker guarantees a minimum death benefit for beneficiaries, which essentially caps the loan's cumulative interest charges.

Importantly, the broker also assumes responsibility for future policy premiums, which lowers the client's out-of-pocket expenses and eliminates any potential tax consequences from the loan. 

When your client needs to raise cash, a whole life insurance loan may be the right strategy—if that client chooses the right type of loan. Often, the broker-funded loan is the lowest-risk choice. It delivers a tax-free cash payment, eliminates insurance premiums and guarantees a minimum death benefit for your client's beneficiaries.

Lucas Siegel is the founder and CEO of Harbor Life Settlements. 

Wednesday, May 18, 2022