Should you take a Loan against an Insurance Policy

Is it a good idea to raise a loan against your insurance policy? The answer can be a yes or a no, depending on circumstances.

Not all Policies Offer loans

First things first: Not all policies can be used to raise loan. General insurance policies have no provision for loan because by nature these are indemnity policies. This means that these kinds of policies have no current value: only on claim will they acquire a value that is equal to the claim paid out. Life insurance policies can be used to raise a loan. The amount of loan is determined by the current surrender value of the policy. Surrender value is the value one will get from the insurance company if he decides to voluntarily terminate the policy. Because surrender values are the function of the number of premiums paid, generally older policies will have accumulated greater surrender value as compared to newer policies. By extension, this means that the proportion of loan on older policies will be higher than on newer policies. There are other factors like the duration of the policy contract that will impact the amount of surrender value, but for general purposes it may be assumed that under similar policies, the older the policy, the greater the surrender value. Term insurance policies that pay out only on death are policies that have no surrender value. Therefore no loans are possible on term policies.

However, not all life insurance policies can be used for loan. New policies may not have accumulated enough surrender value to generate a loan. Some policies may have generated a surrender value, but the quantum may not be enough to cross company guidelines on minimum value that can be paid out. Some policies by nature of contract may not grant loan. Typical amongst these are policies that offer a survival benefit in terms of periodic payouts.

Insurer may be Less Insistent on regular EMI

Loans can be raised from the insurance company itself or from an external lending agency like a bank. In both cases the quantum of loan will be decided by the current surrender value and in both cases the policy will have to be assigned to the lender. By executing an assignment, one transfers the ownership to the lender, who then has first rights over the proceeds of the policy. In both cases, interest will have to be paid to service the loan. By and large insurers charge a lower rate than commercial lenders; however this may not be true in all cases. While the external commercial lender will insist on payment of interest, the insurer may not be particularly insistent. The reason for this is that since surrender value is consistently rising on payment of every premium, the insurer is confident that his loan is recoverable along with outstanding interest. If premium payment stops, the insurer will calculate the outstanding loan and interest and if it exceeds the surrender value, he will forfeit policy proceeds.

With Insurance loans you take upon yourself a higher quantum of Risk

By now it should be obvious that loans may be availed only if the need is critical enough. Any loan reduces the overall risk cover, because the insurer at claim payout will reduce the claim by the amount of loan. The choice of the lender will be decided by interest rates and other factors, however it is obvious that loans from the insurer are more convenient to process and may have a faster turnaround time. Ensure that interest is regularly paid to prevent accumulation of interest amounts and prevent a possible forfeiture of policy proceeds.