Many types of loans are difficult to obtain in these credit-crunch times. However, you might get needed cash by borrowing against your life insurance policy.

Advantages: Such loans require no complicated paperwork, no credit check and no proof of income. Interest rates are reasonable — and you don’t have to pay the interest if you choose not to.

Downside: The loan balance, including any accrued interest, will be subtracted from the insurance benefit that you presumably bought to protect your loved ones. And if you borrow more than the policy’s cash value, you can wind up with a big tax bill (explained below).

Moreover, any loan interest you pay to preserve your policy’s benefits is not tax deductible. To know whether a life insurance loan makes sense for you, consider…

FOREVER FUNDS

Life insurance policy loans are available if you have a so-called “permanent” cash value policy — one designed to stay in effect as you grow older. You can’t borrow from a term life policy, which remains in effect only for a specific period and has no cash value.

There are various kinds of permanent life insurance, including whole life, universal life and variable life policies. Policyholders pay much higher initial premiums for such policies than they do for term life. In return, the policies accumulate “cash value” over time. Ultimately, that cash value can pay the increasing cost of life insurance premiums as you grow older. In addition, the cash value can serve as collateral for loans.

THE COST OF CASH

An example can illustrate the pros and cons of policy loans.

Example: Jane Jones bought a permanent life policy at age 50. Ten years later, she had paid in $100,000 and had accrued $120,000 in cash value ($100,000 of premiums plus $20,000 of investment income). At that point, she borrowed $100,000.

Note: Jane did not actually borrow from her policy. She borrowed from her insurer, using the insurance policy’s cash value as collateral.

With $120,000 in cash value, Jane was able to obtain a $100,000 loan, less than the $108,000 (90% of cash value, which is the maximum you are allowed to borrow) limit on loans in her case. She can use that money in any way she wants, and she owes no income tax on it.

Downside: Policy loans usually charge interest rates comparable to the yields on highly rated corporate bonds.

Assume that Jane is charged compound interest of 6% a year but chooses not to pay any of this interest for 12 years. At that point, her loan balance would be around $200,000.

Trap: Although Jane continues to earn money on her $120,000 in cash value, which earns money because it is treated as an investment account, she won’t earn as much as she would have earned if she hadn’t borrowed any money.

Typically, the amount borrowed ($100,000 in this example) will earn interest at a rate that’s one to two percentage points lower than the rate earned on the rest of the cash value ($20,000).

Result: The loan balance will grow faster than the cash value. Jane’s cash value might be only $190,000 when the loan balance reaches $200,000.

NEGATIVE THOUGHTS

As mentioned, a policy loan uses the borrower’s cash value as collateral. Jane’s $190,000 in cash value is no longer enough to back a $200,000 policy loan balance.

What will happen: The insurance company will ask Jane to pay the $10,000 difference.

Each year, the loan balance may grow faster than the cash value. The amount that Jane will have to pay probably will increase each year.

Trap: If Jane does not make any of the required catch-up payments, her insurance company will report Jane’s income to the IRS. That income will be the amount by which her loan exceeds the total of premiums she has paid for the policy.

Suppose that this occurs when Jane’s loan is $200,000. She has paid $100,000 in premiums, so she will owe tax on $100,000 in income. That’s phantom income — income she’ll never pocket — because the entire cash value will be used to pay off the policy loan.

Not only will Jane owe a substantial amount of income tax, she’ll also no longer have the life insurance coverage she wanted.

CUTTING COVERAGE

If Jane dies while her policy is still in force but with an outstanding policy loan, the loan will be repaid to the insurer and the death benefit will be reduced by that amount.

Suppose that Jane dies when her policy’s cash value is $190,000 and her loan balance is $188,000. Further suppose that the policy’s death benefit is $300,000.

Result: Of the $300,000 death benefit, $188,000 will go to the insurance company, settling the loan. Only $112,000 will go to Jane’s beneficiary.

DON’T BORROW TROUBLE

Considering how policy loans are treated, pursue the following strategies…

  • Treat life insurance policy loans as a last resort. Borrow only if you have a vital need for cash, not for nonessentials, such as a luxury vacation, a second home or your daughter’s wedding.
  • If you do have a critical need for cash and it’s not possible or practical to get another type of loan, borrowing against your policy can generate cash at a reasonable interest rate.

  • Don’t borrow the maximum amount. Rather than borrow 90% of the amount of your cash value, borrow a smaller portion. That will reduce the risk that your loan balance will grow to exceed your cash balance.
  • Pay the loan interest each year. That will prevent the loan balance from growing and enable you to maintain a death benefit for your beneficiaries.
  • Monitor statements from your life insurer carefully. If the loan balance exceeds the cash value, promptly pay enough to make up the shortfall. This will keep you from incurring a huge tax bill.