Taking loan against insurance as collateral? Know risks and benefits

You must know that not all life insurance policies can help you with a loan facility. Karthik Raman, Head of Products at Ageas Federal Life Insurance, said, “You can generally take a loan against life insurance policies which have a cash value at maturity. Both participating and non-participating traditional savings policies offer a loan against your policy.” In the case of participating policy, the insurer shares profit with the insured in the form of bonuses and dividends. While in the case of a non-participating policy, you get maturity benefits, and the insurer doesn’t share any form of bonuses or dividends with the policyholder. The policies that can provide a loan facility include money-back, endowment, or whole-life policies. Raman said, “Since term plans do not have a cash value at maturity, you cannot take out a loan against such policies.”

Moreover, you may also not avail loan against unit-linked insurance policies (ULIPS). Sunil Sharma, chief actuary and chief risk officer of Kotak Life Insurance, said, “ULIPS allows the policyholder to take partial withdrawal rather than a loan.” Readers should note that policies with a cash value and ULIPs mix insurance and investment. While you can borrow against them, mixing investment and insurance is not generally advisable.

Loan requirement: You could consider taking a loan against your life insurance policy when you might urgently require a significant sum of money. For instance, you may need cash for an upcoming wedding, making a down payment on the house, paying off a creditor, a medical requirement, etc. The lenders can help you provide a loan amount equal to a maximum of 90% of the surrender value of your policy. When applying for the loan, you have to submit a loan application form, insurance policy and a signed agreement to the lender. This way, you can take a loan from a lender using the cash value part of your policy as collateral.

“The loan amount available would be a percentage of the surrender value of the policy applicable at the time of taking the loan. Typically, the policy acquires a surrender value at least three years from its inception and becomes eligible for you to take a loan. There would also be an applicable interest rate on your loan, usually linked to a standard interest rate,” said Raman.

Loan tenure: The tenure of the loan cannot exceed the policy maturity date. Typically, the lender assigns a loan term equal to the policy term.

How to repay: You can repay the loan as equated monthly instalments (EMIs) in part or entirely at any time before the policy matures. Repayment terms may vary from lender to lender. Besides, you must pay all dues before the policy term ends and check whether the lender applies any pre-payment charges.

While paying loan EMIs, you will also have to pay all premiums on time during the policy term so that policy doesn’t lapse. Ashwini Bondale, Senior Vice President, ICICI Prudential Life Insurance, said, “If you cannot repay the loan, the life insurer/lenders will offset the outstanding loan amount against the maturity benefit or surrender value as the case will be. In cases where the outstanding loan amount exceeds the policy surrender value, the insurer can foreclose the policy.”

However, if the policyholder has paid all due premiums, the policy cannot be foreclosed. Sharma said, “For such policies, the amount paid on death or maturity will be the death benefit or guaranteed maturity benefit reduced by the outstanding loan amount, respectively.”

Charges: When you take a loan against the policy from a lender, you will have to pay an interest rate between 10% and 15%. The lender may also charge processing fees up to ₹2000 (inclusive of GST), foreclosure or pre-payment, and bounce charges. Besides, lenders can apply penal interest (around 2%) and annual maintenance charges.

Should you borrow? Borrowing money from a life insurance policy has benefits like a reasonable interest rate compared to a personal loan interest rate, a quicker approval process and no fixed instalments for repaying the loan. Sharma said, “The advantage of a policy loan is that it helps the policyholder to finance its immediate liquidity needs while keeping the life insurance policy in force. However, you must consider policy loans as a temporary option to get liquidity. Also, you must repay it as soon as surplus money is available to reap the original benefit from the policy.”

Adding to it, Bondale said, “Loans against policies are available to insured at competitive interest rates compared to other routes of seeking loans.” However, Raman said, “If you have borrowed money against your life insurance policy, then in the case of your unfortunate demise, the insurer will clear off the unpaid loan amount from the death benefit due to your beneficiaries. Your beneficiaries will, therefore, receive only a partial death benefit due to them. Another risk is that the policy will auto-terminate if the outstanding loan amount with accumulated interest exceeds the policy’s surrender value.” One must remember that on surrender, the policy terminates, and, in that case, you cannot take the benefit of insurance coverage.

Point to note: In case of any emergency, you must consider looking at other financial instruments to raise funds because a life insurance policy is only to financially secure your family in the unfortunate event of your death.