Financially Speaking: Know rules on borrowing from a life insurance policy

One of the basic components of a comprehensive personal financial plan is an analysis of risk exposure.

For most families, the premature death of a breadwinner, particularly when children are young, can be financially devastating. In most of these types of situations, the purchase of term life insurance will provide the largest amount of death protection at the most efficient cost, but sometimes more permanent forms of insurance coverage are more appropriate.

Many types of insurance policies are designed to accumulate cash value over time. The insurance industry has done an excellent job marketing the advantages of such policies, some of which include the ability to take tax-advantaged withdrawals (under current tax law, at least) and the ability to borrow against their cash value. I'll reserve the controversial topic of insurance as a retirement planning vehicle for another column. Today, I'd like to concentrate on the features and pitfalls of policy loans.

As access to credit has become a greater challenge, life insurance policy loans have become an attractive alternative to cashing in policies as a source of funds for people who may be unable to obtain money from other sources. Credit checks are not required. The loan interest rates of many older policies can be quite attractive compared to credit card cash advances or other types of loans. Most policy loans do not require repayment, a feature that can be helpful to a borrower who has serious cash flow difficulties. Some policy loans are structured to use the cash value as collateral for the loan instead of being withdrawn. In these cases, the entire cash value balance continues to generate dividends, earnings, in the form of interest for whole life and universal life policies, or appreciation potential for variable policies.

Potential pitfalls of policy loans are numerous, however:

Loan balances, plus accrued interest, are subtracted from the policy's death benefit. You might jeopardize the financial security of your family if you die prematurely without replacing the diminished death benefit with alternative coverage.

If you cancel a policy that has an outstanding loan balance, you'll receive its cash or surrender value, less the balance on the loan and accrued unpaid interest.

If you don't make an interest or principal payment, the unpaid interest will be added to the loan principal, which will increase the amount of interest that will accrue the following year.

If you never make any interest or principal payments, your loan balance will grow at a pace that is likely to erode your cash value.

If your loan balance exceeds your cash value, the insurance company will ask you to make a premium payment to cover the difference to keep the policy in force. If you cannot do so, the policy may lapse, which will result in the loss of the entire death benefit.

Depending upon your age and health status, you might not be able to replace the coverage.

In addition to the risk of losing your life insurance protection, you might also be hit with a tax bill if you cancel a policy whose loan balance exceeds the cumulative amount you paid into the policy. The difference between the loan balance and your cost basis in the policy may be considered taxable income.

If you are considering a policy loan, proceed cautiously. Be sure you understand all of the requirements and potential costs and risks to avoid inadvertently damaging your family's financial security.

Elaine Morgillo is a certified financial planner and president of Morgillo Financial Management Inc. She can be reached at emorgillo@morgillofinancial.com.