What's an insurance policy loan, and when should you cash in on it?

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Policy loans can provide cash in a pinch, but can impact your insurance portfolio. Here’s what you need to know before applying for one.

When a sudden need for cash arises, most of us know to turn to banks for a personal loan. However, did you know that there is another source – other than banks, pawnshops or licensed moneylenders – from which you can borrow the money you need?

And that depending on circumstances, may not even need to pay the money back?

Relax, we’re not suggesting anything nefarious or illegal. What we are referring to are policy loans, which are only available on certain types of insurance policies.

In practice, taking a policy loan looks a lot like borrowing money from yourself. However, what actually happens is that you pledge your insurance policy as collateral in order to obtain a sum of cash.

But what is the collateral that is being used for the loan? What happens if you do not pay back the loan? And since you’re essentially borrowing money from yourself, do you even need to pay it back?

What is a policy loan and how does it work?

A policy loan is a type of loan that is issued by an insurance company. It utilises the cash value of the insurance policy as collateral for the loan.

This means that in order to obtain a policy loan, you first need to be a policyholder. And because the collateral used is the cash value of the policy, only insurance policies that have a cash value can offer a policy loan.

You may also need to wait till your policy generates sufficient cash value before applying for a policy loan capable of meeting your needs.

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Q1: Are policy loans available on all insurance plans?

No, policy loans are not available on all types of insurance plans. They are only available on plans with a cash value that accumulates over time.

These include most whole life policies, as well as endowment and annuity plans. See the table below for a (non-exhaustive) summary.

Policy loan possible Policy loan not possible
Whole life or universal life Term life
Endowment plans Investment-linked policy (ILP)*
Annuity plans Policies bought with CPF

Q2: How will taking a policy loan impact your insurance plan?

Firstly, the policy maturity value will be greatly affected as the cash value that was supposed to be compounding has been reduced. This can impact your financial plans, especially if you take out a large loan that leaves only a small amount of benefits.

Secondly, interest will be charged on your policy loan, which can be steep. You need to pay attention here because if the added interest causes the total loan value to outstrip the cash value of your insurance plan, it will likely lapse, leaving you with no protection.

Thirdly, taking a policy loan does not cause your insurance plan to terminate, as it is not the same as surrendering your policy. Hence you’ll need to continue paying your premiums in order to keep your policy in force.

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Q3: Do you need to repay your policy loan?

Strictly speaking, no, you do not need to repay your policy loan. This is because you are essentially borrowing against your own assets.

As such, policy loans do not have a stipulated loan repayment date, leaving it up to your own discretion on how to manage the loan.

Q4: Should you repay your policy loan?

Well, if you are willing to forego a portion of your insurance benefits, you may choose not to repay your loan, in favour of meeting other financial needs.

However, at the very least, you should cover the interest charges on the policy loan to prevent the loan amount from growing larger than the cash value, in order to avoid premature termination of your plan.

On the other hand, if you are sure you do not want the policy any longer, consider surrendering it so you can wrap things up neatly. The surrender value may be higher than what the policy loan provides.

Ultimately, whether to repay your policy loan or not is a question of balancing between present and future needs.

*Regular paying investment linked plans (ILP) has a feature that is similar to an ‘automatic premium loan’. When premiums are not paid, the units of investment are deducted to keep the policy in force. Once the cash value or units are fully deducted, the policy will lapse.

When should you take a policy loan?

Now that you understand how policy loans work, you may be wondering if you should apply for one, instead of going for, say, a bank loan.

To help answer that question, let’s compare the two.

Policy loans Bank loans
Secured loan, does not count towards Balance-to-Income Ratio Unsecured loan, impacts Balance-to-Income Ratio
No obligation to repay Legally obliged to repay
No fixed repayment term or due date Fixed repayment term with monthly instalments
Interest likely lower than bank loans Interest likely higher than policy loans
Loan amount depends on accumulated cash value Loan amount depends on monthly salary
Only available on selected insurance plans Available as long as you qualify
Loan guaranteed as long as within limits of cash value

From the table above, we can see that we should use a policy loan when we:

  • Are over-leveraged, with the unsecured debt close to or exceeding 12 times monthly income
  • Are unsure about being able to pay it back in full
  • Have the right type of insurance policy that has accumulated sufficient cash value 
  • Need a guaranteed source of cash  

Conversely, we should go for a bank loan when we:

  • Do not have unsecured debt approaching 12 times monthly income 
  • Are sure of being able to pay back the loan
  • Require a larger loan amount than the policy loan
  • Do not have the correct insurance policy or there is insufficient cash value

This article was first published in SingSaver.com.sg.