Any time you apply for a loan, the lender considers the risk that you can’t pay it back. To help reduce this risk, the lender may require you to put up collateral, which is anything of value you pledge as security for repayment. If you fail to repay the loan, the lender receives that collateral.
In some cases, you might consider using your life insurance policy as collateral. Here’s what to know about this option.
What Is Collateral Assignment of Life Insurance?
Collateral assignment of life insurance occurs when you use your life insurance policy’s value as collateral to secure a loan. If you default on the loan or pass away before repaying the entire balance, the lender receives a payout from your policy.
Which Life Insurance Policies Can You Use as Collateral?
If you already have an existing policy, you may be able to use it as collateral. But some lenders may require you to get a new, separate policy.
Lenders typically have specific requirements your policy must meet, such as the type of insurance and coverage amount. Some lenders may allow you to use term life insurance, but most require a whole life policy that builds cash value. The cash value is important because you can access it while alive, providing security even if you don’t pass away. A term policy is only payable at your death.
Your policy’s face value typically must be at least as much as your loan balance, and you must maintain your policy until you fully repay the loan. Failure to maintain your policy violates your loan agreement. The lender may raise the interest rate for the remainder of your loan term or even “call” your loan, which requires you to repay any remaining balance at once.
How Does the Collateral Process Work?
Using life insurance as collateral is common in business lending. For example, suppose you want to start a business and need $65,000. If you don’t have sufficient assets or income to support the loan, the lender may require you to pledge a life insurance policy as collateral. In this scenario, assume you have a whole life policy with a current cash balance of $70,000 and a death benefit of $400,000.
If the lender accepts this policy, you’ll formally list the lender as a collateral assignee on your life insurance policy. Ask your insurer for the necessary form; the provider will ask for the lender’s information so it can contact the lender if a payment needs to be made. Once the appropriate paperwork is complete, you’ll finish the loan application with the lender using the life insurance as collateral.
Once the loan is funded, you continue paying your premium as normal.
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What’s the Difference between a Collateral Assignee and a Beneficiary?
Naming a lender as a collateral assignee isn’t the same as listing it as a beneficiary, so follow the correct process. A collateral assignment limits the payout to the unpaid loan balance and expires once the loan is repaid. Meanwhile, a beneficiary designation has no connection to the loan. A beneficiary receives the death benefit regardless of whether you have an outstanding loan balance when you die.
What Happens If You Default on the Loan?
If you default on your loan or pass away before you pay off your loan completely, a portion of your death benefit is used to pay off the remaining balance. This reduces the payout your beneficiaries receive. To offset this risk, you may want to consider getting an additional policy or temporarily increasing your death benefit.
Other Lending Options to Consider
Although collateral assignment of a life insurance policy can make the difference between qualifying for a loan or not, you can weigh other options too.
Borrowing from Your Life Insurance Policy’s Cash Value
If your policy has sufficient cash value, you could borrow directly from that amount and avoid needing a lender altogether.
Withdrawing from Your Policy’s Cash Value
You could withdraw your policy’s cash balance. If you only withdraw a portion of the cash balance, your policy remains in force. However, you could also surrender your policy and withdraw the entire cash balance. In this case, you typically no longer have insurance coverage, and you may owe taxes and penalties on a portion of the withdrawal.
Applying for Unsecured Loans
Not all loans require you to post collateral. You could take out an unsecured loan from your bank or credit union.
Your Life Insurance Can Work for You
While most people purchase life insurance to provide financial security for their loved ones after passing, policies can also be used for special purposes. Assigning life insurance as collateral for a loan is one way to make your policy work for you while you’re still living.
To learn more about using life insurance as collateral and explore the options available to you, reach out to an experienced financial professional, who can take a close look at your situation and offer personalized guidance.
Insurers and their representatives are not permitted by law to offer tax or legal advice. The general and educational information here supports the sales, marketing or service of insurance policies. Based upon individuals’ particular circumstances and objectives, they should seek specific advice from their own qualified and duly-licensed independent tax or legal advisors.
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