Q. I have a whole life policy with a $500,000 death benefit and a cash value of about $100,000. I want to get rid of $30,000 in credit card debt, $20,000 in student loans and a $50,000 home equity line of credit balance. Should I borrow or take out the cash value to pay it all off, especially with rising interest rates? Are there tax consequences?
A. Yes, those rising interest rates are painful.
We’re sorry to hear you have so much debt, but it’s great that you’re looking at strategies to pay it off.
Before deciding on using your life insurance policy’s cash value, you need to compare the interest rates on your outstanding debt and the interest you would pay for a loan on your policy, said Ed Gaelick, a Chartered Life Underwriter and Chartered Financial Consultant with PSI Consultants in Glen Rock.
He said you should compare the rates to see if it makes sense to borrow against the life policy, noting it could make sense for some but not all of your current loans. .
“And to clarify, you are not borrowing from your whole life policy,” he said. “You are using the cash values in your whole life policy to borrow from the Insurance company. They use your policy values as collateral. That’s why there’s a loan interest charge.”
The repayment for a life loan is very flexible so it may be a benefit to some, but it could also be a detriment to others who may not be as diligent with repayment, he said.
There is no tax consequence to borrow money against your life policy, Gaelick said, But if you surrender your policy, there would be income tax on any amount above your “cost basis” or how much premium was paid into the policy over the years.
He offered this example. Let’s say your total cumulative premiums were $80,000. If you surrender the policy and receive $100,000, you would pay income tax on the $20,000 gain.
“The tax rates would be your marginal or outside tax bracket. There is no capital gains tax treatment with a surrender,” he said. “Plus, once you surrender your policy, there is no longer any death benefit. So if maintaining the benefit is important to you, don’t surrender. Instead, consider borrowing. Premiums will need to continue to be paid with a loaned policy.”
Gaelick had one other note: If the loan rate for your home equity line of credit is more favorable than borrowing against your life policy, maybe consider increasing that loan to pay off the student debt and credit cards.
Consider meeting with a financial planner to see if there are any tax benefits for using the home equity line of credit, he said.
Email your questions to [email protected].
Karin Price Mueller writes the Bamboozled column for NJ Advance Media and is the founder of NJMoneyHelp.com. Follow NJMoneyHelp on Twitter @NJMoneyHelp. Find NJMoneyHelp on Facebook. Sign up for NJMoneyHelp.com‘s weekly e-newsletter.