When you apply for a loan, the lender wants to make sure you have the financial resources to repay your debt. In some cases, the underwriter may ask you to provide a form of collateral. This is typically something of value that you pledge to forfeit to the lender if you default on the loan.
Depending on your circumstances, you may be able to use your life insurance policy as a form of collateral. This could help improve your approval chances for a loan or a mortgage, but there are some important things to understand before utilizing it. Learn how collateral assignment in life insurance works, explore the upsides and downsides of choosing this option, and some alternatives you may want to consider.
What Does It Mean to Have Collateral Assignment of Life Insurance?
Collateral assignment of life insurance allows the lender to be the primary recipient of your life insurance policy’s death benefit if you have an outstanding loan balance when you die. Some assignments also allow the lender to tap into the policy’s cash value if you default on your loan. While using life insurance as collateral does not prevent you from naming your own primary and contingent beneficiaries, it does mean that the lender is paid in full before anyone else. Once the loan balance is covered, your named beneficiaries receive whatever is left.
In some cases, collateral assignment allows the lender to take over your entire policy if you stop making payments on your loan. If you stop paying your policy premiums, the lender may also take over premium payments and add the cost to your principal balance. Collateral assignment can vary depending on the lender and the insurance carrier, so it’s important to carefully read all documents before signing any agreements.
When Is Collateral Assignment Used?
Although life insurance collateral can be used for many types of lending agreements, collateral assignments are commonly used for mortgages and business loans rather than for student loans or credit card debt. They are also not used for unsecured loans, as these types of loans do not require collateral.
It’s fairly common for a lender to request collateral assignment of whole life insurance and other types of permanent life insurance policies since they have a cash value that’s accessible at any time. This may allow the lender to access the cash value upon your default instead of only having protection when you die.
How Life Insurance Collateral Works
When you take out a loan with an assignment of life insurance, the application process is similar to the process for other types of loans. The main difference lies in the assignment of the insurance policy, which you can do by contacting the insurance carrier and requesting the required paperwork.
If you and your spouse co-own a life insurance policy, you must both agree to the assignment and be listed as co-assignors. If your spouse does not agree, you cannot use that policy as collateral. It’s also important to note that lenders generally limit the amount of your policy value that you can use for collateral. For example, you may only be able to use 50% to 90% of the policy’s cash value when you collateralize your loan. Each lender and insurance carrier may have different rules, so it’s important to confirm this before completing your application.
In some cases, you may also need to get permission from the life insurance company to use the policy as collateral. Once the request is approved and the paperwork completed, the lender can move forward with the underwriting process and either approve or deny your loan request.
When you’ve paid off your debt, you can contact your insurance carrier and let them know you need to release the collateral assignee for your life insurance. As long as your loan has been paid, the lender cannot make a claim against your policy, even if you forget to take this step. However, collateral assignments must be settled before funds are distributed to your beneficiaries, so completing this process can help your beneficiaries avoid unnecessary delays.
Term vs. Permanent Life Policies
Lenders generally prefer permanent policies for collateral assignment, but some may accept a term life policy as long as the insurance coverage term lasts at least as long as your loan term. Each lender is different, so you need to confirm the requirements when applying for your loan.
The lender may also prefer a permanent policy because it can provide access to its cash value. Since term policies have no cash value, there’s no recourse for the lender until you die and they’re able to access the policy’s death benefit.
Current vs. New Policies
Some lenders allow you to collaterally assign a life insurance policy you already have in place, while others may require you to take out a new policy. Your ability to use an existing policy also depends on whether the insurance company allows collateral assignment.
Some insurance companies also do not allow you to complete a collateral assignment during the application process. In this case, you need to finish the process of setting up your policy, then file paperwork to complete the life insurance assignment. Keep this in mind when determining your timeline to complete the required steps.
Assignees vs. Beneficiaries
When assigning a lender to our policy, you do not name the lender as your beneficiary. Instead, you name the lender as an assignee and designate your beneficiaries in the same way you would with a non-assigned life insurance policy.
If you die before you finish repaying your loan, the lender receives the outstanding loan balance. Your beneficiaries then receive the remainder of the death benefit. If you’ve named multiple beneficiaries, they each receive their designated percentage of the remaining balance.
Should You Consider Using Your Life Insurance as Collateral?
While using your life insurance as collateral may be an option for you, it’s important to carefully consider the pros and cons of doing so. This can help you determine whether it’s a good option for you or if you may want to consider an alternative.
Pros
If your bank requests a life insurance collateral assignment, you may consider agreeing based on the following advantages:
- Improved loan approval odds: Assigning your life insurance policy as collateral may help you get approved for a loan so you can reach your financial goals, such as starting a business or buying a home.
- Asset protection: When you use a life insurance policy as collateral, you’re not risking other assets, such as your home or retirement account.
- Affordable rates: Due to the certainty collateral assignment adds to a loan application, lenders may be willing to offer lower interest rates on collateralized loans.
- Tax benefits: When you use a life insurance policy as collateral, there are no tax implications. This may not be the case if you take out a policy loan or a withdrawal.
Cons
While collateral assignment may initially seem like a great idea, there are some potential drawbacks to consider before making your decision:
- Estate planning issues: If you die before your loan is paid off, the collection of collateral could throw off your estate plan and leave your beneficiaries without the financial security you originally planned to provide.
- Loss of control: When you use an insurance policy as collateral, you’re required to keep it in place until the loan is paid off. Otherwise, the lender could take out another policy on your behalf and add the premiums to the principal of your loan.
- Limited access to cash value: Some forms of collateral assignment may limit your ability to access your policy’s cash value, which reduces your financial flexibility.
- May require a new policy: Some lenders do not allow borrowers to use existing policies as collateral, and taking out a new policy requires time, effort, and additional expense.
Alternatives to Collateral Assignment
If you’re not sure that collateral assignment is the right option for you, then you might consider exploring some alternatives. Here are a few options that may help you get the cash you need.
Utilize a Life Insurance Cash Value Loan
Rather than assigning your policy to the lender, you could directly tap into your cash value by taking out a life insurance loan. However, to take advantage of this option, you need to have your policy in place long enough to build up sufficient cash value, which can take several years. When you die, your unpaid loan balance and interest charges are also deducted from the death benefit.
Cash Surrender
You may consider giving up your permanent life insurance policy and taking the cash surrender value. Before choosing this option, keep in mind that it requires canceling your policy, potentially leaving you without coverage or in need of a replacement policy. You may also be subject to penalties if your policy is still in the surrender period when you initiate the cancelation.
Take Out a Home Equity Loan
If you’re not comfortable using your life insurance policy as collateral, you may consider taking out a home equity loan instead. This type of loan uses your home as collateral rather than your life insurance policy. This may also be an option if you do not already have a life insurance policy in place or your lender requires you to take out a new policy and you have health issues that prevent you from being approved for life insurance coverage.
Take Out an Unsecured Loan
Unsecured loans are not backed by collateral. This could be an option if you do not want to take the chance of losing your current assets. However, keep in mind that unsecured loans may be harder to get and typically have higher interest rates than collateralized loans.
Take Out a Term Life Insurance Policy
In some cases, the lender may not require collateral assignment, but borrowers want to ensure their debts are paid upon their death. You can accomplish this by purchasing a term life insurance policy with a term that is equal to your loan term. This allows you to sidestep the collateral assignment process while still providing your heirs with the funds needed to pay off your remaining debt. The beneficiaries can also use any remaining death benefit as they see fit.
As you weigh your options, consider how each alternative fits with your current needs, risk tolerance, and comfort level.