Taking out a loan on your insurance policy. Should you or should you not?

By Vinod Nair, Founder and Chief Executive Officer of MoneySmart.sg:

What does Singapore keep pumping money into year after year and still have something to show for it: Life insurance policies. Because long before you as the insured pass on and your family receives a lump sum of money as the beneficiary, you get to cash in on your life insurance policy – when you are still and very much alive!

There are three types of life insurance every Singaporean should understand. They are term life insurance, endowment policies, and investment-linked policies. For simplicity sake, here are the overarching differences:

(a) Term insurance gets you the most coverage for the least cost, but you don’t get anything in return.
(b) Endowment policies are insurance policies that also have a guaranteed return at maturity.
(c) Investment-linked policies are insurance policies that also double as investments.

So not only do you have a guaranteed return at maturity, there is a good chance you might get more than just the guaranteed return – I’m talking cold, hard cash. If I may adopt an analogy: Insurance is like a car, term insurance is like renting a car – you pay for what you use, but you never own the car, and an endowment policy is like buying a car – you pay more than if you rent, but the car is yours. Investment-linked policies are like driving with Uber – you own the car, and if you want, you can use the car to make money.

And when can I get back this money?

You don’t get back any money with term life. But with endowment policies and investment-linked policies, there is a maturity date. This is usually between 10 and 20 years. If you die or suffer from total permanent disability or critical illnesses – depending on the policy – before maturity date, your dependents will get a payout. If you survive up to the maturity date, you get the payout.

What if I need money now?

If you need money urgently, and you have a life insurance policy, you can actually take out a life insurance loan. This is also known as a policy loan.

How does a life insurance loan work?

Now, with life insurance, you have something known as a cash value. This cash value is basically how much you will get back if you choose to cancel the policy. That means the cash value will increase over time, as you pay more premiums. A life insurance loan borrows money from the insurance company using the policy’s cash value as collateral. Instead of cancelling the policy and taking the money, and losing out on any future benefits, you just loan that amount, with interest. In other words, it is like borrowing from yourself.

How much can you get from a life insurance loan?

Most insurance companies allow you to borrow up to 90 per cent of your cash value. Remember that this cash value is based on the premiums you’ve already paid, and not the amount you can expect at maturity. You can’t borrow from your future self.

When can you get it and how?

Depending on the amount, you can make an urgent request to get your loan within hours in the form of a cheque. Otherwise, it will take up to two to three days to issue a cheque or directly credit your bank account.

What is the interest rate charged on this loan?

Depending on the insurance company, the interest rate is anything between 5 and 7 per cent per year. However, be sure to check how interest is calculated. Usually, it will be compounded on an annual basis. If it is compounded on a daily basis, forget about borrowing from yourself – your self-generated loans costs simply too much.

How does a life insurance loan compare to personal loans?

At 5 per cent to 7 per cent interest per year, a life insurance loan is cheaper than most personal loans. Not only that, life insurance loans give you a flexibility of repayment that personal loans cannot. By that, I mean that most personal loans require you to pay back a fixed amount monthly, and you will be penalised if you make full repayment early.

That’s right, if you actually have the money and want to repay the loan early, you’ll get charged more. Life insurance loans don’t have this condition. However, because the amount of a life insurance loan is based on your policy’s cash value, there is a chance you may not be able to loan as much compared to a personal loan, which depends on your monthly salary.

Life insurance loans sound great!

If your loan and interest together exceeds the cash value of the policy at any time, your policy may be terminated. This is usually not a good thing as the whole point of the policy is for it to mature or at least, provide coverage in the event of death or total permanent disability. Because there is no fixed monthly repayment schedule, the insurance company has the right to change the interest rate at any time. They probably won’t, of course, but just be aware of what you’re getting yourself into.

At the end of the day, if you are going to be paying higher premiums for an endowment policy or an investment-linked policy, you should at least know that you can get something out of it if your cash flow is affected. Life insurance loans provide a relatively convenient and cheap means of borrowing money.