Should You Borrow Against Your Cash Value or Withdraw It?

Should You Borrow Against Your Cash Value or Withdraw It?

February 26, 2022
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Need a chunk of change? Perhaps it’s an emergency, perhaps it’s a business opportunity, or it may simply be a periodic major purchase such as a new car. Either way, it’s bound to happen. You’ve got a need for cash, and you have to decide whether to get the cash from a credit card, a retirement account, a home equity line of credit, or somewhere else.

Would it surprise you to know that if you’ve been paying permanent life insurance premiums, you’ve been saving just for this situation? Your premiums don’t just contribute to a death benefit after all. You also get benefits, such as your cash value, to use while you’re living. This is just one of the reasons that permanent life is such an efficient financial product. 

So how do you use the money you’ve accumulated in your policy? Should you take a policy loan or simply withdraw the money from your cash value? (Many people talk about “borrowing” their cash value but that is incorrect. You can either withdraw it, or borrow against your cash value.)

Withdrawing Cash Value is Simple

You simply take it out and go! Yet there is a long-term impact to withdrawing your cash. Withdrawal means liquidation, which means you lose that part of your asset. You cannot put money back into your policy, so ultimately you have less cash value left to earn dividends, grow for the future, or borrow against. It’s important to consider the opportunity cost of this decision. However, for many people, there’s an advantage to having no interest charges or penalties. (Though you may pay some income taxes, depending on how much you take.)

Borrowing Against Cash Value is ALSO Simple

When you borrow against your policy, you take a loan from the life insurance company with your cash value as collateral. When you do this, you usually have your money within a week. There are no qualifications required (other than sufficient cash value). Most companies will loan policy owners up to 90% or more of their cash value balance, while the cash value still earns dividends. However, you must pay interest on the loan, which currently varies between 1-5%, depending on the company.

In this post, we’ll give you our rules of thumb to help you decide which is right for you—a cash value withdrawal, or a policy loan.

Advantages to Using a Policy Loan

Some “pros” to using a policy loan are:

  • While you pay back your policy loan, the underlying cash value you are collateralizing keeps growing.Your cash value continues to earn, which offsets the interest you pay.
  • There are no qualifications required for your loan, other than having the cash value to borrow against.
  • You can pay back the loan on your own schedule, fast or slow, steadily, or in a lump sum.
  • You pay interest on an annual basis. Of course, you can pay it any time during the year. 
  • Loans are tax free (as long as your policy remains in force, and your repay your loans eventually).
  • Permanent life policy loans do not affect your credit and are not tracked by the IRS, credit reporting agencies, banks, or anyone other than you and your insurance company.
  • Should you find yourself unable to pay the loan, you could still pay for it with your cash value, liquidating that part of the asset, but erasing the loan.

What Are the Disadvantages?

The main disadvantage to policy loans are, obviously, the interest. And contrary to common urban legends, you do NOT pay the interest “to yourself.” At least, you’re not doing so directly. Instead, the interest you pay goes to the insurance company (who services your loan). The interest you and all policy owners pay to the insurance company benefits the company. 

The main advantage of withdrawals is simple—you don’t have to pay it back! It’s your money, and you are free to take it without penalty or taxes (yet only up to your basis).

Cautions About Policy Loans and Withdrawals

Some reasons you might not want to borrow against your policy include:

  • Withdrawals are treated as taxable income if you take more out than what you put in to the policy. If you withdraw repeatedly, you risk creating taxable events.
  • Withdrawals reduce your current and future cash value. Your growth rate is based on your cash value amount.
  • When you withdraw money, you cannot “put it back.” That is simply the rule of insurance. You can pay NEW premium, and earn NEW cash value. However, you cannot “put back” withdrawn money into your cash value.
  • Policy loans, as well as withdrawals, reduce your death benefit. (This is not a terrible thing in most cases, as a properly set up policy will have an escalating death benefit over time.)
  • Interest continues to accrue on unpaid policy loans. If you have no plan to repay, and you expect to live decades longer, withdrawing may be a better option.

Managing Your Permanent Life Policy for Maximum Benefit

The financial mainstream trains consumers to avoid debt and “pay with cash.” So it might seem like a no-brainer to simply withdraw your funds rather than take a loan. Yet if you look at your whole financial picture and consider the potential future opportunity costs of this decision, you may see things differently. You finance everything you buy. You either pay interest, or you lose interest you could have earned by "paying cash". 

Some Questions to Consider:

Do you have the means to pay a policy loan back?

If you have steady income, or even a history of steady income, policy loans make perfect sense. Perhaps you work on contract and are just in between contracts. Or perhaps your income is not the issue, you just simply had a large expense or purchase. Even if it may take months, even years to pay it back, if you believe you can pay it back, the loan may be the way to go. That way, your cash value can continue to benefit from uninterrupted compounding growth. This is a perk that a regular savings account cannot be used for.

You may also be interested to know that as the policy owner, you have a significant amount of control over your loan. While you cannot dictate the interest rate, you can control your repayment schedule completely, making it more flexible than a credit card or bank loan. So if you have the means to repay, a loan is a great option.

How old are you? What are your circumstances?

If your financial professional has built and funded the policy properly, you can take a policy loan, and even create an income stream for retirement. You can have this peace of mind because your death benefit will cover your outstanding balance.

If you are younger, withdrawing is going to have a greater negative impact on your savings. As a general rule, we advise someone who is active and has sufficient income to pay off a policy loan to borrow against their cash value rather than withdraw. However, if you feel you have limited prospects for future income sufficient to repay the loan (and don’t want your life insurance to lapse), withdrawal is the better option.

Is your need for money temporary?

If you need the money for a limited time only, a policy loan probably makes the most sense. You don’t want to compromise your long-term savings because of a temporary need, if possible. (Yet again, consider your age and circumstances.)

Are you using the money to create more money?

Permanent life insurance makes a great companion to real estate investing, because it’s an ideal vehicle to provide short-term cash for investments. With real estate investing (and many other businesses), you can have short-term cash flow needs, and be able to use that money to generate a return, which allows you to pay off what you have borrowed.

We even have clients that borrow against their cash value to make short-term, fixed-rate loans secured against real estate or other assets that can bring them returns MUCH higher than their cost of obtaining the money through the policy loan. We call this strategy dual compounding - and here is a case study. (This should only be done cautiously, but can be a powerful wealth-building strategy when carefully considered.)

Have you measured and considered your opportunity costs?

When making a major purchase, such as a new roof or a new car, many policy owners actually strategize intentionally to borrow against their life insurance cash value. In this way, they minimize the opportunity cost of paying cash.

We are trained to measure interest paid on debts, yet learn very little about opportunity cost. This concept helps you identify interest not earned when you save in a bank and pay cash, rather than storing that money where it can grow. Opportunity cost is every bit as important to measure as the interest you’re paying (if not more so). We either “pay up or pass up” interest, and it is critical to have MORE MONEY working for you than less money, even if it creates temporary debts in the process.

To Borrow Against or Withdraw: Which is the Best Option for You?

It is essential to consult with a true life insurance specialist before purchasing your cash value life insurance policy and they can help you construct your policy to meet your goals and objectives when it comes to taxes, death benefit payouts, income, even how you may wish to use policy loans.

If we can help you set up a life insurance policy, consider your available options, or answer any questions you have about insurance, we’d love to hear from you. You can connect with us here.