Policy Loan

What is a Policy Loan?

A policy loan is a unique financial instrument that allows an individual to borrow money using the accumulated cash value of a permanent life insurance policy as collateral. Unlike conventional loans from banks or credit unions, a policy loan is not issued by a third-party lender. Instead, the policyholder is essentially borrowing their own money, with the life insurance policy's cash value serving as the guarantee for repayment. This means the loan does not appear on credit reports and typically does not require a credit check, offering a private and accessible source of funds.

How Policy Loans Work

When you take out a policy loan, the insurance company does not actually lend you money from its general fund. Instead, it uses your policy's cash value as collateral and advances you the funds. Your policy's cash value continues to earn interest or dividends, though the portion used as collateral for the loan may earn a reduced rate or be subject to a 'wash loan' provision where the interest earned equals the interest charged. The loan amount, plus any accrued interest, reduces the death benefit paid to beneficiaries if the policyholder passes away before the loan is fully repaid. There is typically no fixed repayment schedule, offering significant flexibility, but interest continues to accrue until the loan is satisfied.

Key Characteristics

• No Credit Check: Eligibility is based solely on the policy's available cash value, not the borrower's credit history.
• Flexible Repayment: Policyholders can repay the loan at their own pace, or not at all, as long as the policy remains in force. However, interest continues to accrue.
• Interest Rates: Rates are typically fixed or variable, often competitive with other forms of secured lending, currently ranging from 4% to 8% depending on the insurer and policy type.
• Reduced Death Benefit: Any outstanding loan balance, plus accrued interest, is deducted from the death benefit paid to beneficiaries.
• Tax Implications: Generally, policy loans are tax-free as long as the policy remains in force. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount may be treated as taxable income up to the gain in the policy.

Strategic Uses in Real Estate Investing

For real estate investors, policy loans can be a powerful tool for accessing capital quickly and efficiently, especially when traditional financing options are less favorable or time-consuming. Their flexibility and lack of credit scrutiny make them attractive for certain investment scenarios.

Bridging Gaps and Down Payments

Investors can use policy loans to cover down payments on new properties, especially when they need to act fast on a good deal. It can also bridge short-term financing gaps, such as covering closing costs or initial renovation expenses while waiting for a traditional mortgage or construction loan to close. This allows investors to secure properties without liquidating other assets, which might incur capital gains taxes or disrupt long-term investment strategies.

Emergency Fund for Properties

Real estate investments often come with unexpected expenses, such as major repairs or sudden vacancies. A policy loan can serve as a readily available, low-friction emergency fund, allowing investors to address issues promptly without dipping into their operating capital or taking out high-interest short-term loans. This can prevent small problems from escalating into costly ones.

Step-by-Step Process for Obtaining a Policy Loan

Accessing a policy loan is generally straightforward, involving a few key steps:

1. Verify Cash Value: Confirm the available cash value in your permanent life insurance policy. This is the maximum amount you can borrow.
2. Contact Your Insurer: Reach out to your life insurance company or agent to initiate the loan request. They will provide the necessary forms and details regarding interest rates and terms.
3. Complete Application: Fill out the policy loan application form, specifying the desired loan amount. This typically involves minimal paperwork.
4. Receive Funds: Once approved, the funds are typically disbursed quickly, often within a few business days, directly to your bank account.
5. Manage Repayment: Decide on a repayment strategy. While flexible, regular payments can prevent the loan from eroding your policy's value and death benefit.

Real-World Example: Funding a Fix-and-Flip

An investor, Sarah, identifies a promising fix-and-flip property for $200,000. She has $50,000 in her whole life insurance policy's cash value. She needs $40,000 for the down payment and an additional $10,000 for immediate renovation supplies before her hard money loan funds. Here's how a policy loan could be utilized:

• Available Cash Value: Sarah has $50,000 in her policy.
• Loan Request: She takes a policy loan for $50,000 at a fixed interest rate of 5.5%.
• Deployment of Funds: $40,000 goes towards the down payment, and $10,000 covers initial renovation costs.
• Repayment Strategy: Sarah plans to repay the $50,000 loan, plus interest, from the profits of the fix-and-flip project within 6-9 months. If the project sells for a $75,000 profit, she can easily repay the loan and restore her policy's full death benefit and cash value growth.
• Benefit: This allowed her to secure the property and start renovations immediately, without waiting for other financing or selling off other investments.

Important Considerations and Risks

While policy loans offer significant advantages, it's crucial to understand their potential downsides. Unpaid interest can compound, rapidly increasing the loan balance. If the outstanding loan balance, including accrued interest, exceeds the policy's cash value, the policy can lapse. A lapsed policy with an outstanding loan can trigger a taxable event, where the loan amount is treated as a distribution and any gain in the policy becomes taxable income. This can have severe financial consequences. Therefore, careful management and a clear repayment strategy are essential when utilizing policy loans for real estate investments.