Life insurance can be a key component of long-term financial planning. Just like homeowners insurance or auto insurance, you buy life insurance and pay premiums for the coverage. If you, the policyholder, die while the policy is in effect, the listed beneficiaries—such as relatives or charities—will receive a payout called a death benefit.
But while a policyholder is alive, they may want to tap into the value that already has accumulated. You may be able to extract money from your life insurance policy. However, the ability to treat the policy like an ATM depends on what kind of life insurance you have. It's also important to know that withdrawing money from your policy leaves less for your heirs when you're gone.
If you have a permanent life policy, you might be able to pull money from the policy when you're still alive by dipping into its cash value. Types of permanent life insurance policies include whole life, universal life and variable universal life. These policies hold a cash value beyond the death benefit (known as the face value).
The other category of life insurance is term life. You can buy this kind of coverage for a certain period of time, or term, such as 10, 20 or 30 years. The policy pays the listed beneficiaries if the policyholder dies during the term. This coverage does not carry a cash value, meaning the policyholder can't take advantage of the policy's value.
Read on to find out how you can take advantage of the value of your life insurance policy, the pros and cons of doing so, and what alternatives are available if you need cash.
How Does Withdrawing From Life Insurance Work?
If you have a life insurance policy with cash value, you have several options for extracting value from it while you're still alive:
- Withdrawing money from the policy
- Surrendering the policy
- Borrowing against the policy
- Using the policy to pay your premiums
Withdrawing Money From a Life Insurance Policy
You might be allowed to withdraw money from a life insurance policy with cash value on a tax-free basis. However, if the sum you take out surpasses the amount of money you've built up as the cash value under your policy, you'll be required to pay income taxes on that money.
Generally, you can withdraw money from the policy on a tax-free basis, but only up to the amount you've already paid in premiums. Anything beyond the amount you've already paid in premiums typically is taxable.
Withdrawing some of the money will keep your policy intact. Withdrawing all of the money will cancel the policy.
While it might make sense in certain circumstances to pull money from the policy, it will eat into the benefit that is paid to your beneficiaries when you die. Plus, you could face an unwanted tax bill. Situations where it may be not be a bad idea to withdraw money from a policy include:
- Paying for college tuition
- Covering an aging parent's health care expenses
- Making a down payment on a new home
Surrendering a Life Insurance Policy
Surrendering a policy happens when you withdraw the full cash value of your life insurance. In this case, wiping out the cash value effectively cancels your coverage. When you surrender your policy, you'll receive the sum of money you've paid toward your coverage plus any interest you've earned, but minus any unpaid loans or premiums. Potential disadvantages of surrendering a policy include being hit with surrender fees and federal income taxes.
Borrowing Against a Life Insurance Policy
You can take a loan on the cash value of a life insurance policy without needing to go through a credit check. But any unpaid balance will subtract from the death benefit. In this scenario, it's important to balance your current needs against your long-term goals.
Potential uses for a loan taken out against a life insurance policy include paying off a home mortgage, covering a child's college tuition or taking a vacation. You'll be charged interest on the loan, usually in the range of 5% to 8%. If the loan and interest aren't paid before you die, the loan balance and fees will be deducted from the death benefit.
You aren't required to pay back a life insurance loan, but interest will keep accumulating until it's paid off or until you die.
Applying Cash Value to Policy Premiums
If you're strapped for cash, you may be able to lean on the cash value of your life insurance to help cover the policy premium. However, if you completely drain the cash value doing so, your policy may lapse and your coverage then would disappear.
Alternative Ways to Get Money Fast
Rather than siphoning the cash value of a life insurance policy, consider the following alternatives, which can give you quick access to cash without jeopardizing your coverage.
A personal loan can be a smart choice when you need money for a big purchase or to consolidate higher-interest credit card debt. Personal loans often charge lower interest rates than credit cards do. You can get a personal loan through a bank, credit union, online lender or peer-to-peer lending platform.
Before you apply for a personal loan, assess your financial situation to make sure you can afford the monthly payments. Check your credit score to see whether it's strong enough to qualify you for the best rates and terms. In addition, check your credit report to ensure there are no inaccuracies that may hurt your ability to obtain a personal loan.
0% Intro APR Credit Card
Depending on why you need the money, a 0% intro APR credit card is another alternative to pulling cash from a life insurance policy.
Some cards provide promotional 0% intro APR offers for transferring balances from high-interest credit cards, for purchases, or for both. During the promotional period, interest charges won't accumulate as long as you make on-time payments for at least the minimum amount due.
A 0% APR credit card may be a better option than a low-interest personal loan if you're sure you can pay off the credit card balance before the promotional period ends and the interest rate increases.
Cards with 0% intro APR promotions often require good credit. Before you apply, do your research so you apply for a card you're likely to qualify for. Experian CreditMatch™ can provide you credit cards that fit your credit profile when you sign up for free.
Credit Card Cash Advance
Most credit cards let you borrow a certain amount of money through what's called a cash advance. This could be a few hundred or even a few thousand dollars.
While this may be an option for a short-term cash crunch, a cash advance usually comes with fees as well as an interest rate that's higher than the card's standard rate for purchases. A cash advance also might lower your credit score by pushing up your credit utilization ratio. If you won't be able to pay back the cash advance amount quickly, this is probably not your best option.
Home Equity Loan
A home equity loan enables you to borrow against a slice of your home's equity at a fixed interest rate. You can compute your home's equity by subtracting the balance on your mortgage from the current market value of your home. Among the common uses for a home equity loan are big purchases, home renovations and emergency expenses.
Interest rates on a home equity loan frequently are lower than the rates for credit cards and personal loans. But the downsides of a home equity loan include being dinged by closing costs (roughly 2% to 5% of the loan amount), keeping you in debt for a longer period and risking foreclosure on your home if you fall behind on the loan payments.
The Bottom Line
Before you decide to draw on the cash value of a life insurance policy, consider how it will affect your long-term financial goals. Also explore alternatives to coming up with quick cash, such as a personal loan, 0% APR credit card, credit card cash advance or home equity loan. Whichever path you choose, carefully evaluate how it will impact your future financial life.