Creative Finance 201: How to Use Life Insurance to Buy Real Estate
Buying a property can be a challenging and rewarding process, but it also requires a lot of money. You need to save for a down payment, qualify for a mortgage, and pay for the closing costs and fees. However, if you have a life insurance policy, it could help you buy a property in a couple of ways:
Lenders may accept your policy as a form of collateral. By putting up your life insurance, you could improve your chances of qualifying for a mortgage and at a lower interest rate. If your life insurance policy has cash value, you could take that money out through a loan or withdrawal and put it toward your home purchase.
In this article, we will explain how these two methods work, what are the benefits and drawbacks of each, and what are the best practices for using life insurance to buy a property.
What is Life Insurance and How Does it Work?
Life insurance is a contract between you and an insurance company that pays a death benefit to your beneficiaries when you die. It can cover natural, accidental, suicide, homicide, illness or injury, war or terrorism deaths. It can also offer living benefits or cash value. Learn the types, purposes, costs and benefits of life insurance.
There are two main types of life insurance: term life and permanent life. Term life covers you for a fixed amount of time, usually 10, 20, or 30 years, and pays a death benefit if you die within that term. Term life is cheaper and simpler than permanent life, but it does not accumulate any cash value or offer any living benefits. Permanent life covers you for your entire life, as long as you pay the premiums, and pays a death benefit whenever you die. Permanent life also accumulates cash value over time, which you can access through loans or withdrawals. Permanent life can also offer living benefits, such as paying a portion of the death benefit if you are diagnosed with a terminal, chronic, or critical illness. Permanent life is more expensive and complex than term life, but it offers more flexibility and benefits.
The main purpose of life insurance is to provide financial protection and security to your loved ones in case of your death. Life insurance can help your beneficiaries cover expenses such as funeral costs, debts, mortgages, education, or income replacement. Life insurance can also help you achieve your estate planning goals, such as leaving a legacy, creating a trust, or donating to a charity. Life insurance can also help you access cash while you are alive, either through loans or withdrawals from your cash value, or through living benefits from your death benefit.
The benefits of life insurance are that it can provide peace of mind, financial security, and wealth creation for you and your beneficiaries. Life insurance can help you protect your family from the financial impact of your death, and ensure that they can maintain their standard of living and achieve their goals. Life insurance can also help you access cash for your needs and wants, such as buying a property, starting a business, or retiring comfortably. Life insurance can also help you reduce your taxes, diversify your portfolio, and increase your net worth.
Using Life Insurance as Collateral
One way to use life insurance to buy a property is to use your policy as collateral for a mortgage loan. This means that you pledge your death benefit to the lender as a security for the loan. If you die before paying off the loan, the lender will collect the remaining balance from your policy. If there’s any money left over, it then goes to your heirs.
When you use life insurance as collateral, a lender could be more likely to approve your mortgage application. They also might approve you for a lower interest rate, reducing how much you need to pay per month and over the course of the loan.
However, not all types of life insurance can be used as collateral. Lenders are more likely to accept a permanent life insurance policy, such as whole life, universal life, or variable universal life. These policies don’t have an expiration date. They last your entire life, as long as you keep paying the premiums.
Alternatively, term life insurance has a set expiration date. For example, a five-year term policy lasts five years. If a lender accepts a term policy as collateral, the policy typically must last at least as long as your mortgage.
If you don’t already own life insurance, you could buy a policy to use as collateral. For suggestions, see our review of the best life insurance companies of 2023.
When you use life insurance as collateral, you need to sign a collateral assignment agreement with the lender. This agreement states that the lender has the right to claim the death benefit of your policy if you default on your loan. You also need to notify your insurance company about the arrangement and get their approval.
If you use life insurance as collateral, you agree to keep your policy and continue making all the premium payments. You also agree to not cancel your policy or change the beneficiary without the lender’s consent. If you cancel your policy, your lender could increase your interest rate or demand immediate repayment of the loan. If your policy has cash value, the agreement could restrict your access to it until you’ve paid off the loan.
Using Life Insurance Cash Value
Another way to use life insurance to buy a property is to use your cash value. This is money that builds up in your policy from your premium payments. The insurance company also provides a return on your cash value balance. If your life insurance policy has cash value, you could take this money out through a loan or withdrawal and put it toward your home purchase.
However, not all types of life insurance have cash value. Only permanent life insurance policies, such as whole life, universal life, or variable universal life, offer cash value. Term life insurance policies don’t build cash value. They only offer the death benefit.
If you have a permanent life insurance policy with cash value, you have several ways to take money out of your policy to buy a property. Each has different rules, advantages, and disadvantages. Many real estate investors will use a special type of whole life policy for a strategy called infinite banking.
Infinite banking is a concept that involves using a permanent life insurance policy, such as whole life, as a personal line of credit. The idea is to overfund the policy with extra premium payments, which build up the cash value of the policy. The cash value can then be used to borrow money from the policy and finance various purchases, such as real estate, cars, education, or business ventures. The policyholder can then pay back the loan with interest, which goes back to the policy and increases the cash value and the death benefit. The policyholder can also receive dividends from the insurance company, which can be reinvested in the policy or used for other purposes.
This is complex and out of scope of this article, but it another approach.
Withdrawal or Partial Surrender
One way to take money out of your policy is to make a withdrawal or a partial surrender. This means that you take out a portion of your cash value and reduce your death benefit by the same amount. For example, if you have $50,000 in cash value and a $100,000 death benefit, and you withdraw $10,000, you will have $40,000 in cash value and a $90,000 death benefit.
The advantage of making a withdrawal or a partial surrender is that you don’t have to pay interest or fees on the money you take out. You also don’t have to repay the money to your policy. The disadvantage is that you will have to pay taxes on the money you take out, if it exceeds the amount of premiums you’ve paid into your policy. You will also reduce your death benefit and your cash value growth.
Loan
Another way to take money out of your policy is to take a loan. This means that you borrow money from your policy and use your cash value as collateral. For example, if you have $50,000 in cash value and a $100,000 death benefit, and you take a $10,000 loan, you will still have $50,000 in cash value and a $100,000 death benefit, but you will owe $10,000 plus interest to your policy.
The advantage of taking a loan is that you don’t have to pay taxes on the money you borrow, as long as you repay the loan. You also don’t reduce your death benefit or your cash value growth, as long as you repay the loan. The disadvantage is that you have to pay interest on the loan, which may be higher than the return on your cash value. You also have to repay the loan to your policy, or it will be deducted from your death benefit when you die.
Full Surrender
The last way to take money out of your policy is to make a full surrender. This means that you cancel your policy and receive the entire cash value as a lump sum. For example, if you have $50,000 in cash value and a $100,000 death benefit, and you surrender your policy, you will receive $50,000 and lose your $100,000 death benefit.
The advantage of making a full surrender is that you get access to all of your cash value at once. The disadvantage is that you will have to pay taxes on the money you receive, if it exceeds the amount of premiums you’ve paid into your policy. You will also lose your death benefit and your insurance coverage.