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Loan Against a Life Insurance Policy – Important Things to Know

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Loan Against a Life Insurance Policy – Important Things to Know

The main function of a life insurance policy was originally, to provide protective cover. However, life insurance is a far more versatile investment option nowadays, also giving policyholders the benefit of availing a loan against the life insurance policy.  So, not only does it provide security, but it also helps when one is going through a cash crunch. What’s more, loans against life insurance policy are becoming a popular choice for customers, since a lower rate of interest is charged in comparison to a personal loan. One additional benefit of loans against life insurance policyis that the policy value does not change with the market as in the case of loans against gold or shares.

There are however a number of factors one needs to bear in mind before opting for a loan against a life insurance policy:

Eligibility of Policy

You need to confirm whether your policy qualifies for a loan first and foremost, as all insurance policies do not provide this benefit. You can take a loan against the surrender value of permanent or whole life insurance but not against term insurance. Unlike other plans, term plans do not contain cash value and they expire at the end of the term without earning returns; hence the limitation. If you have paid premiums for at least 3 years and on time then you may avail of a loan, as far as non-term plans go.

When borrowing a loan against an insurance policy, you are essentially borrowing from yourself. You can thus borrow the money for any kind of expense without having to provide an explanation, and you do not have to undergo intense scrutiny or a stringent approval process. Though the income of the borrower is also not a deciding factor for deciding their eligibility, their credit-worthiness is considered nevertheless.

Loan Amount

You need to check the amount you are eligible for, with the insurance company or the bank. The loan amount is a percentage of its surrender value. Loans can be up to 85-90% against traditional plans with guaranteed returns. Not all unit-linked policies provide loan facilities, but if they are provided, then the loan amount depends on the current value of the corpus and the type of fund.

Once the loan amount is decided, then the policy is assigned to the lender. This means that all rights of the policy are transferred to the lender, and the loan is sanctioned to the borrower thereafter. Furthermore, since the loan amount is not recognized as income by the Income Tax authorities, it is not taxable.

Interest Charged

The interest rate charged in case of loan against insurance policy is based on the premium already paid and the number of premiums that have been paid. The more the premium amount and number of premiums paid, the lower the rate of interest charged.

Banks link the rate of interest with their base rate, in most instances. Since banks consider loans of this nature like an overdraft facility against pledging of the insurance policy, it can be more expensive in comparison to the loan provided by life insurance companies. The rate of interest of bank loans are between 10-14%, based on the type of insurance and tenure of the loan.

Life Insurance Corporation of India currently charges a rate of interest at 9% that needs to be paid half-yearly. They have a minimum tenure of 6 months, so even if you want to repay the loan before 6 months you have to pay interest for 6 months.

Documentation Needed

The policyholder would have to contact the insurance company to enquire about the process and documents needed. A pre-prescribed form will have to be filled, and the original insurance policy will have to be submitted. The policyholder would also have to sign a deed of assignment which states that the benefits of the policy are being assigned to the lender during the loan tenure. The policy will act as collateral till the loan is repaid.

Premiums

Upon taking a loan against a life insurance policy, policyholders need to continue paying premiums. In such an event where the policyholder desists from doing so, some insurers may terminate the policy.

Repayment of Loan

The loan should be repaid during the term of the policy. The policyholder has the option of either paying back the principal along with interest or only the interest amount. If one pays only interest, the principal amount due will be deducted from the claim amount at the time of settlement.

Furthermore, if the policyholder should choose to pay back only the interest, in the event that they die during the loan term, the pending amount due will be deducted from the claim amount and only what remains will be paid to the nominee. One should bear in mind the fact that the dependents of the policyholder will not be the sole beneficiaries of the policy if the policyholder should die unexpectedly before the loan is repaid. Policyholders should thus exercise caution while taking up a loan against a life insurance policy because the policy is supposed to protect one’s loved ones in the event of their death. By using the policy to take up a loan, the nominees of the policy might be deprived of this benefit.

It is thus prudent to pay back the loan in a timely manner as the interest keeps getting added to the balance whether the loan is being repaid or not. This increases the risk of the loan amount exceeding the policy’s cash value, which can cause for the policy to lapse. In such a case, taxes might have to be paid on the cash value. In case of non-payment of the loan, the amount owned will be taken from the accumulated surrender value of the policy and the policy will be terminated.

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