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Insurance Policy Loan – What Is It, and When Should You Use It

We commonly think of an insurance policy as something that only comes into play on some far off day in the future. This perception is understandable, given the way insurance policies are designed to work.

An insurance policy only pays out when an insured event comes to pass, or alternatively, when a predetermined period of time has passed. After the benefits have been paid out, the policy terminates.

Securing you and your family’s future is undoubtedly important, but if you’re facing an immediate need for cash, you may not regard your insurance policy as being particularly useful.

But don’t dismiss your insurance policy just yet. Depending on the type of policy you have, you may be able to tap on it for the funds you require.

And you can do so while keeping your policy in force, allowing you to continue being protected.

What is an insurance policy loan?

A policy loan is a feature that is commonly found in certain types of insurance policies.

A policy loan is exactly what it sounds like – a loan taken out against an insurance policy that you own. This is possible because some insurance policies, such as life insurance, and endowment plans, build up a cash value.

Now, this cash value makes up part or all of the benefits you receive when a claim is made. But up to that point, it is simply sitting in your insurance policy, earning interest at a rate determined by your insurer.

This cash value doesn’t appear out of nowhere – it is drawn from the premiums you pay, and builds with every payment. Therefore, this makes the cash value in your insurance policy akin to your savings, in a way.

As such, if you find yourself needing funds, you may make use of the cash value in your policy by taking out a policy loan.

How does a policy loan work?

When you apply for a policy loan, it is important to note that you are not withdrawing money from your policy. Instead, you are borrowing from your insurer, using the cash value in your policy as collateral.

Your insurer extends the loan to you on the basis that the cash value in your policy is retained. (Hence, the insurer does not take on any default risk). Once the loan is disbursed, the cash value is locked up and rendered unavailable, until the loan is paid back.

And because this is a loan, you will be charged interest. The interest rate varies across different insurers and products, and is disclosed as you make the application. It may also be displayed on the insurer’s website, or you could also find out the rate from your financial adviser.

An insurance policy loan sounds very similar to a personal loan. You are borrowing from a financial institution, there is interest charged on the amount you borrow. However, there is one crucial difference between a policy loan and a personal loan.

You do not have to pay back your policy loan, only the interest charged on your loan.

Still, if you choose to pay it back anyway, you can do so at your own pace and schedule. (In comparison, a personal loan requires fixed monthly payments over a predetermined period).

What type of insurance policies offer a policy loan?

Not every insurance policy offers a policy loan. Instead, only policies that are structured to include a cash value will allow you to borrow against it.

Here are some examples of insurance policies that offer a policy loan. Do note that this list is non-exhaustive and non-authoritative – it is ultimately up to your insurer to decide whether or not to offer policy loans as a feature on the plans they underwrite.

  • Whole life policy
  • Universal life policy
  • Endowment plan
  • Annuity plan

Read more: Term Life Insurance vs Whole Life Insurance

Pros and cons of policy loans

Now that you understand what an insurance policy loan is and how it works, let’s take a look at the pros and cons.

Pros of insurance policy loan
Cons of insurance policy loan
On-demand source of funds to meet emergencies
Benefits are reduced by the amount of the policy loan
Need not be paid back, or may do so at own pace and schedule
Not paying interest may cause policy to be terminated
Less stringent eligibility criteria, and approval is virtually guaranteed
Interest charged on amount borrowed
Does not count as unsecured debt
Can only borrow up to your policy’s cash value

Pros of insurance policy loan

  • A policy loan may be used to meet demand for cash on an ad-hoc basis. You may also make multiple borrowings as long as there is sufficient cash value in your policy. This makes a policy loan a highly flexible and convenient option for cash on demand.
  • As highlighted above, you do not have to pay your policy loan back, provided you can accept the implications of not doing so (more on this later). Any repayments you choose to make – whether partially or in full – may be done at your discretion.
  • A policy loan is much easier to apply for, as the eligibility criteria is less stringent. You do not have to fulfil any income requirements, for instance. As you are essentially borrowing from yourself, approval is virtually guaranteed.
  • Another benefit offered by a policy loan is that it does not count as unsecured debt. This means it does not increase your Total Debt Servicing Ratio, and thus would not affect your quota for other borrowings, such as mortgages.

Cons of insurance policy loan

  • When you take out a policy loan, your benefits payable under the insurance policy is reduced by the amount that remains outstanding at the time the payout is triggered. Paying back the loan will restore the level of benefits payable.
  • The interest charged on your policy loan will reduce the value of your policy, and may exceed the surrender value of your policy. At this point, your policy will be terminated. However, this can be avoided by paying off the interest in your policy loan.
  • Even though you are essentially borrowing money from yourself, you are still required to pay interest on your policy loan.
  • The amount you can borrow is limited by the cash value of your insurance policy at the time. Typically, you are only allowed to borrow up to 90% of the cash value in your policy, which may not be sufficient for your needs. Also, as cash values in insurance policies tend to grow slowly in the initial years, a policy that is still young may be unlikely to provide a loan large enough to fully meet your needs.

What happens if you don’t pay back your policy loan?

Although a policy loan is not required to be repaid, not doing so can have some serious implications.

The benefits payable under your policy is reduced by the amount borrowed in your policy loan. As such, if your loan is not paid back, your beneficiaries will receive a smaller amount in total.

This may or may not be an issue, depending on the financial needs of your beneficiaries at the time the policy is triggered. Nevertheless, it is something to bear in mind when using a policy loan.

In any case, always remember that you can pay your policy loan back, and any amount repaid will restore the level of benefits payable to your beneficiaries accordingly.

A policy loan’s best feature is its flexibility

When using a policy loan, perhaps a middle-of-the-road approach is best.

If necessary, go ahead and take a policy loan to meet any current pressing needs, but make plans to pay it back once the immediate danger has passed.

Remember that you don’t have to take on a large loan, only what you need. And with the ability to pay your loan back at your own pace and according to your ability, repaying your policy loan may be done with minimal financial strain.

Arguably, the best feature of a policy loan is its flexibility, so be sure to use it to your advantage.

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