How to Use Life Insurance as Collateral for a Loan

Using a life insurance policy as collateral for a loan allows policyholders to access needed funds. This article details eligible policies, how cash value functions, the preparation required, the assignment process, and managing the loan and policy.

Understanding Eligible Life Insurance Policies

Only life insurance policies that accumulate cash value are suitable for use as collateral for a loan. These permanent life insurance policies provide lifelong coverage and include a savings component, unlike temporary term life insurance which does not build cash value.

Specific types of permanent life insurance policies include Whole Life, Universal Life, and Variable Universal Life. Whole Life insurance offers a guaranteed death benefit and a cash value component that grows at a guaranteed interest rate. Universal Life insurance provides flexibility in premium payments and death benefits, with cash value growth influenced by current interest rates. Variable Universal Life insurance allows policyholders to invest the cash value in various subaccounts. The cash value, not the death benefit directly, is the asset pledged in a collateral assignment.

How Policy Cash Value Works

Cash value is a savings component that grows on a tax-deferred basis over time. A portion of each premium payment is allocated to this cash value account, earning interest or investment returns. The cash value represents a living benefit that the policyholder can access during their lifetime, distinct from the death benefit. Its role as collateral for an external loan allows for significant liquidity. The amount a lender is willing to advance is typically a percentage of the policy’s accumulated cash value.

Preparing to Use Your Policy as Collateral

Before approaching a lender, policyholders should understand their policy’s current financial standing. Obtain an up-to-date statement detailing the accumulated cash value and any outstanding policy loans that might reduce the available collateral.

Gather the original life insurance policy document and a current cash value statement from the insurer to demonstrate the policy’s worth. Information regarding current beneficiaries should also be readily available, as the collateral assignment may impact their claim on the death benefit.

Policyholders should contact their life insurance company to inquire about their specific procedures and forms for collateral assignment. Determine the precise loan amount desired and confirm it aligns with the policy’s available cash value for collateral purposes.

The Collateral Assignment Process

The formal collateral assignment process begins with securing lender approval for the loan. A Collateral Assignment Agreement formally transfers a conditional right to a portion of the policy’s benefits to the lender.

This legal document specifies that the lender has a claim on the policy’s death benefit up to the outstanding loan amount. Both the policyholder (assignor) and the lender (assignee) must sign this agreement.

Following the agreement’s execution, the policyholder must notify the life insurance company of the collateral assignment. This involves sending the completed and signed collateral assignment form to the insurer for acknowledgment and recording. The insurer then notes the assignment on the policy. Once the collateral assignment is in place, loan funds are typically disbursed by the lender.

Managing the Loan and Policy

After a life insurance policy has been assigned as collateral, the policyholder must continue paying premiums to keep the policy in force. If premium payments cease, the policy could lapse.

During the loan term, the death benefit remains active. The lender holds a primary claim against the death benefit up to the outstanding loan balance. If the policyholder passes away before the loan is fully repaid, the lender will be reimbursed from the death benefit first, with any remaining funds distributed to the designated beneficiaries.

Upon full repayment of the loan, the lender is obligated to release the collateral assignment. This requires a formal release document submitted to the life insurance company to remove the assignment from policy records.

Should the loan not be repaid, the lender has the right to access the policy’s cash value to satisfy the debt, or claim against the death benefit if the insured dies. This can reduce the policy’s cash value and the payout to beneficiaries.