Saving enough for a home down payment can be challenging. If you are working toward this, you might be wondering about using life insurance for your down payment. This is a great option, but there are a few things you need to know, including the types of policies you can use, and the process involved.
Life Insurance Types
Not all types of life insurance can be used for a down payment. Understanding the different categories of life insurance is crucial to figuring out if you can use your policy.
Term Life Insurance
Term life insurance covers the policyholder for a set period, typically 10, 20, or 30 years. Term insurance is generally more affordable than other types of policies, but term policies do not accrue cash value, meaning you cannot borrow against or withdraw from these policies. Hence, if you are asking, “can I use life insurance for a down payment?” and you only have a term life policy, the answer is no.
Permanent Life Insurance
Permanent life insurance includes whole life and universal life policy types. These policies do accrue cash value over time, in addition to paying out when the policyholder passes away. That cash value can be accessed through policy loans or withdrawals, which makes borrowing against life insurance for a down payment a feasible way to buy a home.
Using Life Insurance for a Down Payment
If you have a permanent life insurance policy, there are two ways you can access its cash value:
Getting a Life Insurance Loan
One way to access cash for your down payment is to borrow against the accumulated cash value of your policy. This is a popular method of using life insurance for a down payment because it doesn’t involve cancelling your policy or giving up coverage. Essentially, you borrow from the insurance company using the cash value of your policy as collateral.
Because these loans do not require a credit check or approval process, you can have the loan amount relatively quickly. However, it does take time for the cash value of your policy to be high enough to borrow against, so you will not be able to do this right after buying a policy. Typically, a policyholder will have to wait about 10 years before borrowing against life insurance for a down payment.
Withdrawals
You may be able to withdraw part of the cash value of your policy instead of borrowing it. However, this will permanently reduce the amount that the policy will pay out (the death benefit) when you pass away. In addition, withdrawals could be subject to income tax. It is crucial to assess the implications of a withdrawal when it comes to estate and tax planning.
Surrendering the Policy
A final option is to cancel your life insurance policy and receive its full cash value. You should only use this option if you no longer need the life insurance policy. If you decide on this option, you may also have to pay surrender charges, and there could be tax implications depending on how much the cash value of the policy is.
Key Considerations When Using Life Insurance for a Down Payment
Before you decide about using your life insurance for a down payment, be sure to consider all the implications. Some things to take into account are:
Interest Accrual and Loan Repayment
With a life insurance loan for a down payment, interest accrues over time. If you do not pay the interest, it gets added to the loan amount, compounding over time. The best strategy is to repay at least the interest annually, as the interest owing could reduce the payout to your beneficiaries when you pass away. If the interest and loan add up to more than the policy’s cash value, your coverage could even lapse.
Tax Implications
Withdrawals from your policy may be taxable income if they exceed the total amount of premiums you have paid into it. Loans are generally not taxable, but if the policy lapses with an outstanding loan, the IRS may treat the unpaid amount as income. Consult with a tax attorney, financial planner, or accountant to evaluate the tax implications of using your life insurance for a down payment.
Mortgage Lender Requirements
Some mortgage lenders may ask for documentation about where your down payment funds are coming from. Be prepared to show proof of the loan or withdrawal, and ask your lender in advance to make sure this type of funding is acceptable under their lending guidelines.
Should You Use Life Insurance for a Down Payment?
Using life insurance for a down payment is a reasonable plan, but only if you have a permanent policy that has accrued enough cash value.
Before proceeding, consult with a professional who can advise you about your options and the implications of each one. Think about talking to:
- A financial advisor to review the long-term financial impact of borrowing against your policy. A financial planner can also help you with other potential sources of funds for your down payment.
- An insurance broker to talk about the benefits and risks of a life insurance loan for a down payment and about your overall insurance coverage.
- A mortgage lender or mortgage broker to ensure that they can accept this source of funds for the down payment.
- A tax professional to review the tax implications of this type of loan under various scenarios.
With the right planning and guidance, borrowing against life insurance for a down payment can help you buy the home you want.
