Traditionally, life insurance was developed to provide benefits to the family members of a deceased individual. However, over time it has evolved and grown to include many components which make it like an investment for the future. In a way, a life insurance policy becomes a valuable asset of its own accord. It must be noted that not all life insurance policies are the same in every aspect. Certain life insurance policy types like universal, whole, and variable life insurance can be a good option for investment purposes and improve the value of your invested amount.

One of the most pivotal benefits of a life insurance policy is to borrow loans against the sum insured. Many individuals, who do not have other assets to submit as collateral while taking a loan, offer their life insurance policy. While this has become a popular method for people to get instant cash and loans during emergencies, it is essential to point out that this approach has several disadvantages as well. Let’s take a closer look at how these loans work, dive deeper into the specifics of borrowing against life insurance and examine if borrowing against life insurance is, in fact, a good idea or not.

What are Life Insurance Loans?

Before weighing the pros and cons of borrowing against life insurance, let us get a clearer picture of what constitute life insurance loans. Apart from providing the necessary insurance cover, a life insurance policy can also be used to secure a loan in case of an emergency at competitive rates. In other words, a life insurance loan is given by using the value of the insurance policy as the collateral. This facility of obtaining a loan using a life insurance policy is only offered by a limited number of life insurance policies types including universal, whole, and variable life insurance. These life insurance loans are offered by the insurance company, a bank or NBFC which offers loans against securities. 

Furthermore, in case you have a term policy, you will not be able to take a loan against it as it is explicitly meant for providing death benefit protection to your dependants and does not possess any cash value. Also, this facility cannot be used if in case you have invested in ULIPs (Unit Linked Insurance Plans), which invest in equity-oriented securities. 

How Much Can You Borrow Against Your Life Insurance Policy?

The maximum amount of loan which can be borrowed in the form of life insurance loan depends entirely on the surrender value and also the type of life insurance policy. Typically, the maximum loan amount is a percentage of the total surrender value of the life insurance policy. In the case of endowment insurance policies or the traditional-money back policies, the maximum loan amount can be anywhere between 80% to 90% of the total surrender value of the policy.

On the other hand, some of the life insurance policies take 50% of the premiums paid against the policy into consideration when they calculate the maximum loan amount which can be borrowed against a life insurance policy. In some cases, the insurance company or the financing institution may ask you to pay a certain amount as the nominal loan processing fee during the disbursal of the loan amount as well.

Now that we have answered the question “Can I withdraw cash value from life insurance?”, let’s consider the benefits and pitfalls of taking a loan against life insurance policies:

Pros of Loans Borrowed Against Life Insurance

1. Quick and Easy

There is usually no qualification process involved in acquiring a life insurance loan, as the collateral is readily available. As soon as you apply for a loan, you would get the amount within 5-10 business days from most of the life insurance companies.

2. Great Substitute for Emergency Fund

If you do not have an emergency fund, you could land in a pickle in case you have an urgent cash requirement. However, you need not worry if you have a life insurance policy which offers loans. The value of cash in your policy can act as a handy substitute for the traditional form of emergency funds.

3. Loans at a Lower Rate of Interest

When compared to the other types of loans, a life insurance loan can be acquired at a much lower rate of interest. This is because, in case of a mutually-owned insurance company, certain dividends in the form of profits are paid to the policyholders. So basically, companies can earn an interest in a life insurance loan in the form of dividends at a later stage.

4. Not Taxable

In most situations, life insurance policy loans are not considered as income. Although there are a few exceptions, generally the life insurance loans are non-taxable debt instruments. 

Cons of Loans Borrowed Against Life Insurance

1. Fewer Assets to Use

A significant disadvantage of borrowing against life insurance is that you would end up having fewer assets for yourself and a life insurance policy is a critical part of an individual’s investment portfolio. Thus, it is always advisable to consider life insurance loans as a measure of last resort only.

2. Fewer Assets to Your Heirs

Although you need not repay the loan against the value of cash in your policy, if the life insurance loan remains unpaid, it can reduce the total benefits which your dependants would otherwise gain and reduce the utility of the policy for the purpose it was meant for. Thus, the answer to the question “Do you have to pay back life insurance loan?” is no, but doing so will reduce the cash value of your policy.

3. The Risk to Your Policy

Always keep this in mind that the interest on the borrowed amount in case of a life insurance loan will get deducted from the cash value of your permanent life policy. If in case the loan amount exceeds the cash value of your policy, your policy may even lapse. 

4. Time Required for the Cash Value to Build

In order to borrow the loan amount against your life insurance policy, the cash value needs to build. This means that if in case you borrow the loan amount during the early days of your policy, you wouldn’t be able to borrow a significant amount as the cash value wouldn’t have built up. You would need to wait for about 3 years before you can borrow the loan against your newly acquired life insurance policy.

5. Possibility of Taxes

As mentioned above, your life insurance policy can lapse if the loan amount exceeds the cash value of the policy. When such a scenario arises, there is a possibility of it being a taxable event. This means that you would be liable to pay the tax on the remaining loan amount which has not been repaid.

6. No Creditors Protection

Once you borrow the loan amount against the cash value in your life insurance policy, you would lose the protection from creditors on this policy’s cash value, which is available in other traditional loans.

Thus, to answer the question “Can life insurance be used as collateral?” it is essential to understand that any loans taken against the life insurance policy. directly reduce the value of the policy. Therefore, it is essential that you consider this option with the utmost care and consideration. While taking a life insurance loan, make sure you read the terms and conditions carefully, keep track of the interest accrued, and make an attempt to repay it in order to restore the cash value of your life insurance policy. If you are able to manage the loan with caution, you can enjoy the benefits of life insurance loans without having to deal with the adverse outcomes which they may result in.

If in case you are hesitant about borrowing a loan against your life insurance policy as that may pose a certain risk to the policy taken, you can consider other alternatives that provide instant personal loans without a requirement for collateral. For instance, PaySense offers online loans up to Rs. 5, 00, 000 without any collateral or securities. You can apply for an instant cash loan from PaySense using the PaySense mobile app and get an approval on the same day itself. There is no need to visit our office as the entire process is done digitally. Furthermore, you can also upload all KYC documents using the app itself.

Unlike other lenders, PaySense offers customers the freedom to choose their own EMI repayment plan. The eligibility conditions for taking a loan from PaySense are also not as stringent as those in banks. One of the most important requirements is that you should have a minimum monthly income, and you can borrow an amount as per the same. However, since the loans offered by PaySense are unsecured loans, the rate of interest will naturally be higher than those offered by banks. To know more about PaySense personal loans, get in touch with us, get the PaySense instant personal loan app or read more on our website.