At some point in time, a client may consider a life insurance loan.

Unlike other financing options, it’s quick and convenient. In addition, there are no credit checks or requirements. Perhaps the greatest appeal of a life insurance loan, however, is that a client can determine when and how they repay it.

“They can choose their repayment amounts and timeline, or even choose to never repay the loan and consider it a surrender,” said Jake Tamarkin, co-founder and president of Everyday Life Insurance.

Before giving a client the stamp of approval, advisors should weigh the pros and cons of life insurance loans and zero in on how one might help (or hurt) a client’s current situation and future goals.

Where life insurance loans can get risky

Like all financial products, life insurance loans come with drawbacks that are important to convey to clients.

When someone takes out a life insurance loan, their death benefit is reduced by the full amount of the loan balance, so it includes not only the initial loan amount, but any additional interest that has accumulated over the period of the loan.

“If an insured were to surrender a policy, the remaining cash value payout would be diminished by the outstanding loan balance,” Tamarkin explained.

Ultimately, a life insurance loan can affect a policy’s financial performance and reduce how long it remains in good standing.

If there is no plan to repay the balance right away, compound interest will accrue, continually increasing it. When and if the loan balance outgrows the cash value, the policy will lapse.

“Advisors should explain all these potential pitfalls in detail, and in the right situations, help design a loan repayment plan that will keep the policy in force,” Tamarkin added.

When a life insurance loan makes sense (and doesn’t)

Sometimes, a life insurance loan can be a smart financial move for a client.

“A policy loan may be a reasonable financial strategy when the policy is in good structural health, the client has a repayment plan, and the tax implications are low,” Tamarkin said.

Lee Boone, founder of Buckeye Financial LLC, believes it’s particularly worth exploring when a client can predictably use the funds to generate capital, whether through a business opportunity or real estate.

“There is possibility, and there is probability. Advisors never want to make a recommendation based on possibility alone, because that’s how clients often get into trouble,” Boone said.

The decision should be based on probability when the odds are stacked in the client’s favor.

“When that’s the case, a policy loan makes sense, in part because loan proceeds are not taxed the way, say, capital gains from selling stock would be,” Boone explained.

However, if a policy has a low cash value, or the client is unsure if they will ever be able to repay, the risk of lapse is high, and the client should consider another solution.

Also, if the policy is a Modified Endowment Contract, or MEC, the tax implications could make another source of funds a better option.

That’s because MEC loans are treated on a last-in, first-out basis, meaning any loan taken from a MEC is immediately taxable.

How advisors can support clients

When a client expresses interest in a life insurance loan, an advisor must clearly lay out the pros and cons.

“Once a client actually commits to taking out the loan, they need a full circle plan or a clear path back to repaying it, so the funds are there again if they need them in the future,” Boone said.

Clients also need to understand that if the policy is surrendered, voluntarily or involuntarily, or if it lapses while carrying a loan, that outstanding balance reduces the surrender value.

In addition, the gain portion tied to that loan can become a taxable event at that point.

While advisors can’t decide for a client, they can provide the knowledge clients need to make the most informed choice for their unique situation.

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