A previous email addressed the potential for borrowing on one’s life insurance policy; this one will address when such borrowing makes sense. As a reminder, only a policy that has cash value can be borrowed against. The amount available for loan is usually the cash surrender value less the next year’s premium plus the interest on the loan.
My philosophy is that the cash value should normally only be accessed for emergencies or opportunities. You don’t want to take a loan on your life insurance policy to fund your vacation or buy that big screen television you’ve always wanted. Remember, the death benefit will be reduced by any loan still outstanding at the time of death.
Emergencies can have a broad definition and will vary from person to person. A basic rule of financial planning is to have three to six months living expenses liquid, and yet a minority of people actually have that amount in liquid cash reserves. So absent the requisite liquidity, if the roof starts leaking or the vehicle needs a major repair, that would constitute an emergency.
Also falling under the emergency category is creating a loan feature to pay the premium (although this is sometimes used as a specific strategy). If cash flow is tight, the loan feature can be used to keep the coverage in force.
The opportunities I refer to involve income producing opportunities, such as buying a business or perhaps expanding a current business. If no other source of funds is available, it would certainly be appropriate to borrow on your life insurance policy to pursue such an opportunity.
There is a third scenario in which a policy loan could be useful, and that is in a period of disintermediation such as we experienced in the late ‘70s and early ‘80s. Insurance companies have tried to protect themselves from this scenario by changing the loan interest rate from fixed to variable, so that must be taken into consideration before trying to implement such a strategy.
The cash value of a permanent policy is available to the policy owner by way of loan. Although there are several situations where a policy loan is appropriate, careful consideration should be given before taking one, because the face amount of the policy is reduced by the amount of the loan (although it can be restored by repaying the loan).