Life insurance can be a good, even necessary investment for most people. Did you know it can also help you get a loan? Taking out a loan against your life insurance policy is called collateral assignment. Lenders often accept life insurance policies as collateral because it’s a low risk loan; they know they’re going to get their money back.
- What is Collateral Assignment of Life Insurance?
- How does Collateral Assignment of Life Insurance Work?
- What Kinds of Life Insurance Can Be Used for Collateral Assignment?
- Pros and Cons of Collateral Assignment
What is Collateral Assignment of Life Insurance?
In any type of loan, there needs to be some kind of collateral. For a mortgage, your house is collateral, for your car loan, your car is the collateral. If you default, the bank can take your house or your car and sell them, thus getting their money back. If you’re seeking a small business loan, it might be a problem to find collateral to offer to the bank. You could offer the business, but it might not be worth as much as the loan amount. This is where collateral assignment of a life insurance policy comes in.
Collateral assignment is the act of offering your life insurance policy as collateral on a loan. Life insurance that can be used as collateral are cash value life insurance such as whole life or universal life insurance. The reason that these policies can be used as collateral is that they have cash value and even if policy holders can’t afford to pay premium any more, they can still cancel the policy and get cash surrender value to pay back the loan. This makes it easier to obtain a loan, as the bank knows they will get their money eventually.
It is logical that banks don’t lend more than cash surrender value of the policy at the time of lending.
How does Collateral Assignment of Life Insurance Work?
You still have the same beneficiaries as you did on the original policy. You don’t want to name the bank as the beneficiary, because that way, the bank gets the death benefit on the policy when you die—even if you already paid off the loan. So, don’t do that.
You will name the bank as the assignee on the form, and you will be the assignor. The borrower must be the owner of the policy, and the policy must remain current; you still need to pay all of the premiums.
You will then apply for a collateral assignment of life insurance with the life insurance company and the bank. First, the life insurance company will say it’s okay to use your policy as collateral. Then you’ll let the bank know. The bank then proceeds like it would for any other loan: they evaluate the risk involved, and either agree to loan you the money or deny your application.
Some banks will let you use an existing life insurance policy, and some will require that you take out a new policy just for the collateral. If you do have to apply for a new policy, make sure you let the insurance company know that you want the policy to serve as collateral in a loan.
Collateral assignment of life insurance is a limited transfer; in other words, the bank only gets the money on the policy if you default on the loan.
Once the loan is paid off, the bank sends the insurance company a release form. This cancels the assignment and restores the life insurance back to the owner.
If you die or default with your life insurance policy being used as collateral assignment, the lender will take the money still left on the loan, and the rest will go to your beneficiaries. This is why it’s important not to name a bank as a beneficiary. If a bank asks you to name them as beneficiary, find a different bank.
What Kinds of Life Insurance Can Be Used for Collateral Assignment?
You can only use life insurance policies with cash value account as collateral because lenders will lend you against the cash value account in the policy.
- Whole life: You can use whole life policy as collateral, but only if you’ve built up cash value. Should you default on the loan, the lender will have access to the cash value.
- Universal life: Indexed universal or variable universal life insurance policies can also be used as collateral for a loan as long as the cash value account inside the policy has been built up.
- Group life insurance: Some group life insurance such as whole life or universal life group life insurance may qualify for collateral assignment. You need to talk to your benefits administrator. Keep in mind these are usually small policies.
Pros and Cons of Collateral Assignment
Pros:
- Qualification: You can be qualified for loans you might not otherwise
- Affordability: you may be able to offer an indexed universal policy for collateral, and thus pay low rates for a loan
- Protects your other assets. If you own your home, you could offer it as collateral, but if you default, the bank will take it.
- Should you die, your heirs won’t have debt from a loan: the insurance policy pays the bank
Cons:
- Your heirs may get a reduced death benefit
- Getting a qualifying life insurance policy takes some effort
- Loss of control: Until you pay off the loan, the bank is in charge of the policy. They can even buy another policy for you and add those premiums to the principal if you fall behind on the loan.
Last Thoughts
Collateral assignment of a life insurance policy is often used to secure a small business loan. It can help you qualify for such loans, whereas if you didn’t have life insurance, you’d have to put something else up as collateral. Most banks and insurance companies are familiar with the process of collateral assignment of life insurance, and it should be a simple process.