When you need to borrow a substantial sum of money, you may consider several sources. This article compares the risks and advantages of home equity loans and home equity lines of credit (using your home as collateral) and life insurance policy loans (using your life insurance policy as collateral). There are significant differences in risks and advantages between these two money sources.
What Are Home Equity Loans and Home Equity Lines of Credit?
A home equity loan is a loan using the equity you’ve built up in your home as collateral. With a traditional home equity loan, you borrow a lump sum and agree to make regular payments to pay off the loan. A close cousin of the traditional home equity loan is a home equity line of credit (“HELOC”), in which a lender pre-approves a loan up to a maximum amount. You can borrow from time to time against your line of credit. You will be required to make regular payments to restore your line of credit.
If you already have a mortgage on your home, a traditional home equity loan will be secured by a second mortgage. With a HELOC, you’re not signing a mortgage deed, but you’re still pledging your home as collateral. Second mortgages and HELOCs are riskier for lenders, so they generally come with higher interest rates than first mortgages.
Comparing Collateral of a Life Insurance Loan and a Home Equity Loan
“Collateral” is what you agree to surrender to the lender if you don’t pay off your loan. Because you pledge your home as collateral for a home equity loan or a HELOC, you could lose your home if you don’t pay off your loan.
If you don’t pay off your life insurance loan, you may or may not lose your life insurance policy. (See below.) Even if you do, you’ll still have your home.
Home equity loans and HELOCs require that you have built up sufficient equity in your home – typically 30% or more – to serve as collateral. But even with sufficient equity you can still be turned down, if the lender decides you don’t have enough income and a good-enough credit score.
Life insurance loans require that you own a life insurance policy that builds cash value, such as a dividend-paying whole life insurance policy. You must have enough cash value to serve as collateral.
If you have sufficient cash value to back your loan, you cannot be turned down for a life insurance policy loan.
Flexibility of Repaying a Home Equity Loan Compared to a Life Insurance Loan
Sometimes you just need a little extra time to make a payment. Perhaps your mechanic tells you it’s time for a brake job or a new transmission. Maybe the refrigerator goes out. Even with the best of budgets, it’s possible to find yourself short of cash in a given month.
Unfortunately, your home equity lender won’t offer you much leeway. Lenders expect to be repaid – on time – every month.
It’s a different story with a life insurance policy loan. With a life insurance policy loan, you repay the loan on your terms. If you need to skip a payment, just skip it. You won’t get a black mark on your credit report, and you won’t find an overdue notice in your mailbox.
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What Are the Risks of Defaulting on a Home Equity Loan vs a Life Insurance Loan?
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Of course, you have no intention of failing to fulfill your obligation, but too often life spoils our best intentions. There are many reasons why you, a well-meaning and honest individual, might not be able to pay back a loan:
- You may get laid off or fired, or you may have to quit your job for any one of countless reasons
- You may not be able to continue working full time due to medical conditions
- You may face excessive debt and mounting bill obligations
- A divorce or squabbles with a co-owner may temporarily tie up your money
- You may have maintenance issues you can longer afford
If you fall behind in your home equity loan payments, your lender – the holder of your second mortgage – may initiate a foreclosure, forcing the sale of your home out from under you, to recover the money you owe.
Even if your home equity lender decides not to foreclose, they can still sue you. If the lender wins the lawsuit and gets a money judgment against you, they will probably garnish your wages or freeze your bank account.
It should go without saying that a foreclosure or a court judgment against you can ruin your credit rating for years to come. And if you’re forced to declare bankruptcy, you can kiss your good credit rating goodbye for up to 10 years!
Life insurance policy loans have none of these risks.
What About a Home Equity Line of Credit, Compared to a Life Insurance Policy Loan?
While a home equity line of credit (HELOC) is not secured by a mortgage, you have the same obligation to repay as you do with a traditional mortgage. And the lender’s legal options if you default are the same for a HELOC as they are for a traditional mortgage.
There’s something else you must not overlook: your lender can shut down your HELOC unexpectedly, and perhaps with no warning whatsoever.
Can they do that?
Yes! Even though you may have paid big fees to open your HELOC, if you read the fine print you’ll probably find that your lender can freeze, reduce, or shut down your line of credit if any of these things happen –
- The value of your home takes a nosedive
- You don’t make your payments on time
- You and your spouse get divorced or your spouse dies, and you can’t afford the payments on your own
- Your financial condition gets so bad, perhaps due to medical expenses, that you can no longer afford the payments
- You move out of your home – even if you rent it out (a non-owner-occupied home is risky to a lender)
- You take out yet another mortgage
Sure, you can contact your lender and ask what you can do to restore your line of credit. But the chances are, if you have what it takes to restore it, you wouldn’t have lost it in the first place.
If you’re counting on your HELOC to finance a home remodeling, pay for a youngster’s college education, or any other ongoing project, the loss of your loan may force you to make drastic changes in your life plans.
Again, life insurance policy loans have none of these downsides, because …
You Can’t “Default” on a Life Insurance Loan!
On the other hand, you can’t “default” on a life insurance policy loan, because there is no requirement that the loan be paid back. If you die with an outstanding policy loan, the loan balance and any accrued interest will simply be deducted from the death benefit to be paid to your beneficiaries.
However, there is the possibility that while you’re alive, the total amount you owe (your loan balance plus the accrued interest) will approach your life insurance policy’s cash value. If that happens, the policy is in danger of lapsing, which can trigger significant tax consequences.
But there are ways you can avoid that worst-case scenario! If unpaid policy loan interest is increasing your loan balance to the point where the policy could lapse, you have some very helpful options:
- You may be able to convert your policy to a reduced paid up policy. That means that you don’t owe any more premiums, and the insurance company reduces the death benefit of your life insurance policy accordingly. If you do this, the amount of money you had been sending to the insurance company each month to pay your premium can now be used to repay the loan. This can be extremely effective in taming a life insurance policy loan that’s gotten out of hand.
- You can always withdraw dividends from your policy – tax free – up to your cost basis (generally defined as the total premiums you’ve paid in, minus any money you’ve already withdrawn – not borrowed). You can use that to pay down the loan. This will help lower the interest costs and make the loan payments more manageable.
- Simply paying the interest due each year will keep the interest due from causing your life insurance policy to lapse.
These are some of the options that a Bank On Yourself Professional can discuss with you, should the need arise. As you can see, there is a lot of flexibility in avoiding tax consequences due to a lapsed policy when you’re banking on yourself.
Loan Costs for a Home Equity Loan Compared to a Life Insurance Loan
With life insurance policy loans, there are no loan terms such as repayment dates, payment amounts or fees.
Compare that with a home equity loan. With a home equity loan, you’ll have the same fees as with any other mortgage. You’ll find yourself paying …
- Closing costs, such as a title search fee, document preparation and insurance fees
- An appraisal fee to estimate the market value of your home
- An application fee
- Perhaps points (one point equals one percent of the amount you borrowed)
- Even, possibly, an annual loan maintenance fee
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Why Paying Interest on a Home Equity Loan or HELOC Is Worse Than Paying Interest on a Life Insurance Loan
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Home equity interest compounds daily, whereas life insurance loan interest only compounds annually. That difference in how interest compounds raises the cost of a home loan.
But if you have a loan from certain types of life insurance policies, you ultimately get the benefit of the interest you pay, through a combination of guaranteed annual increases, plus any dividends the company pays. This means both the principal and interest you pay ultimately end up in your policy for you to use again – for a car, vacation, business equipment, a college education, retirement, or whatever you want.
Isn’t Home Equity Loan Interest Tax-Deductible?
Not like it used to be! The so-called “Tax Cuts and Jobs Act” changed the rules regarding the tax-deductibility of HELOC and home equity loan interest. After January 1, 2018, deducting this interest will be much more difficult, if not impossible. Talk to your tax planner for the latest IRS interpretations of the tax reform act.
What about 401(k) loans?
Although the primary purpose of this article is to compare the pros and cons of life insurance loans and home equity loans, there is an additional source of capital you may be considering: a 401(k) loan.
We compare 401(k) loans to life insurance loans in this article. Be sure to understand the pros and cons before committing to a 401(k) loan.
And we look at the specific dangers of 401(k) loans in this article. To summarize:
- Applying for a 401(k) loan can be a complicated process
- It can take weeks for your check to arrive
- The government tells you how much you can borrow, how long you can borrow it for, and how you must pay it back
- You won’t be able to borrow more than 50% of your account balance, and never more than $50,000, no matter how much you have in your account
- If you’re 90 days late on a payment, you’ll pay income tax on the balance you still owe, plus a 10% penalty if you’re under 59½
- Some 401(k) plans won’t let you make any contributions while making loan payments. Others make you wait a set time before contributing again after taking a withdrawal. If the contributions you’re not allowed to make are contributions your employer would have matched, you’ll take a double hit
- Thus, your plan’s balance can stagnate if you take out a 401(k) loan
Benefits of Borrowing from a Life Insurance Policy
- There’s no application process – except to tell the company how much money you need and where to send it
- You’ll have your money in a matter of a few days
- There are no restrictions on what you use the money for
- You have full access to 85% or more of your cash value immediately – even if your policy is brand new!
- Your policy can continue growing, just as if you hadn’t touched a dime of it – if your policy is from one of the handful of companies that offers this feature.
Learn more about the eight benefits of life insurance policy loans in this article.
To find out more about the advantages of super-charged, dividend-paying whole life “Bank On Yourself”-type policy loans – and to discover how they can help you eliminate the control banks and finance companies have over you – request a FREE Analysis. You’ll receive a referral to a Professional (a life insurance agent with advanced training on this concept) who will prepare your Analysis and a confidential Personalized Solution.
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Why a Loan Against a Bank On Yourself-Type Life Insurance Policy Beats Other Options
Life insurance policies that have been properly designed by a Bank On Yourself Professional are optimized for policy loans …
- These are high early cash value life insurance policies, meaning they build up cash value far more quickly than ordinary life insurance policies. Cash value is the measurement of how much you can borrow from your policy.
- They’re dividend-paying whole life insurance policies in which the dividends are used to purchase additional paid-up “miniature life insurance policies,” at no additional out-of-pocket cost to you.
- They’re “non-direct recognition” policies. That’s a technical term meaning that when the insurance company determines how much of the annual dividend “pie” goes to you, the company doesn’t “recognize” – it ignores – the fact that you have an outstanding loan. Only a small handful of companies offer this valuable feature.
