Using a life insurance policy as collateral for a loan is a financial strategy that can offer certain benefits to both the borrower and the lender. Here's why someone might consider using life insurance as collateral for a loan:

1. Lower interest rates: Loans secured with collateral often have lower rates than unsecured loans. Lenders view collateral-backed loans as less risky since they can recoup their losses if the borrower defaults. This can result in more favorable terms for the borrower.
2. Easier approval: If you have a life insurance policy with a sufficient cash value, securing a loan against it might be easier than obtaining an unsecured loan. 
3. Quick access to loan funds: Borrowers can quickly access their loan using their life insurance policy as collateral. Traditional loans might involve a lengthier application and approval process, but using a life insurance policy can expedite the borrowing process.
4. Preservation of investments: If the borrower has assets they don't want to tie up for collateral purposes, using a life insurance policy as collateral can be a way to access funds without disrupting their investment portfolio.
5. Flexible repayment: Depending on the terms of the life insurance policy and loan agreement, borrowers might have flexibility in repaying the loan. For example, an individual with a permanent policy that builds cash value could take a distribution from the policy itself to pay down a portion of the loan.  In addition, the death benefit can cover the remaining loan if the insured passes away

Does this strategy work for all loans?

Life insurance can be used as collateral for various types of loans. Still, the availability and terms can vary based on the lender, the type of life insurance policy, and the specific loan purpose. Generally, people typically use life insurance as loan collateral for:

• Personal loans: If your life insurance policy has cash value, you might use it as collateral to secure a personal loan from a bank, credit union, or other lending institution. Personal loans can be used for various purposes, such as debt consolidation, home improvements, or medical expenses.
• Business loans: Small business owners might use their life insurance policies as collateral for business loans. This can be a way to access funding for business expansion, capital expenditures, or operational needs. Business loans often have specific requirements, so it's essential to check with lenders who specialize in business financing.

However, it's essential to consider the following factors:

• Interest rates: While collateral-backed loans typically offer lower interest rates than unsecured ones, the actual rates may vary based on market conditions and by lender. Compare the interest rates of different loan options to determine which is most favorable.
• Loan terms: Different types of loans have varying terms, repayment schedules, and conditions. Choose the loan that aligns with your financial goals and repayment capabilities.
• Loan amount: The amount you need to borrow might influence the type of loan you pursue. Some lenders may have minimum or maximum loan amounts for collateral-backed loans.
• Risk vs. reward: Understand the potential impact on your life insurance policy, such as reducing the death benefit and possible policy lapse if the loan is not repaid. 

What is the best life insurance product to use as collateral?

Various types of life insurance can be used as loan collateral, even term insurance.  Even if a policy does not build cash value, a portion of the death benefit can still be assigned to the lender if the individual passes away prematurely.  Here's an overview of how different types of life insurance policies can be used as collateral, along with their pros and cons:

Permanent Life Insurance (Whole Life, Universal Life, etc.)

Pros

• Cash value: Permanent life insurance policies generally accumulate cash value over time, which can either be used as collateral for a loan or as a source of funds to pay back a portion of the loan at any time.  If the loan is repaid during the insured’s lifetime, the policy is then no longer encumbered and can be used for estate planning or supplemental retirement purposes.  

Cons

• Policy lapse: If the policy is not funded properly or underperforms, it could lapse prematurely, and the insured may have to provide additional collateral.  
• Reduced death benefit: Borrowing against the cash value of a permanent life insurance policy to repay a portion of the outstanding loan reduces the death benefit that will be paid out to beneficiaries upon the policyholder's death.

Term life insurance

Term policies provide coverage for a specific period, and they do not accumulate cash value or savings. Keep in mind if a term policy is used as collateral, it generally must cover the full length of the loan repayment, depending on the lender. For instance, a five-year term policy may be insufficient if the loan must be repaid in ten years. 

Pros

• Low premiums: Term life insurance typically has lower premiums than permanent life insurance, making it a more affordable option.
• Simplicity: Term life insurance is straightforward and focuses solely on providing repayment for the loan.

Cons

• No cash value: Term life insurance policies do not build cash value and are utilized solely for the death benefit.  
• Limited duration: Term policies expire after a specific term (e.g., 10, 20, 30 years). Depending on the lender, the loan repayment terms may not fit within the policy's timeframe. This could leave the lender looking for additional collateral or refinancing options. 

Ideal client profile

Certain client profiles might be more suitable for using life insurance as collateral for a loan. However, it's important to note that each individual's financial situation is unique, and the decision to use life insurance as collateral should be made after careful consideration of their specific circumstances. That said, here's a general profile of an individual who might benefit from using life insurance as collateral for a loan:

• Insurability: First and foremost, a client must be considered insurable in order to obtain a life insurance policy. Generally, this means someone who is in good health, has a strong financial history, and can show justification for needing the policy. 
• Lack of assets or not wanting to tie up existing assets:  This strategy may be most helpful for individuals who either don’t have access to liquid assets to secure a loan or people who don’t want to risk existing assets (like a home) being tied to a loan. 
• Need for life insurance: Using life insurance as collateral can serve two purposes. It can help an individual secure a loan and provide financial security for additional beneficiaries, like family members.

Policy structure: Beneficiary designations

When using a life insurance policy as collateral for a loan, the beneficiary designation must be structured properly. If not, the lender could get more money back than they are actually due, leaving less money behind for secondary beneficiaries like children. 

Here’s an example of how an “in whose interest appears” beneficiary designation can be worded with the policy to avoid this issue:

“Primary beneficiary - ABC Bank, in whose interest appears under loan #12345, dated 1/1/23; remainder to my spouse - Jane Smith, 123-45-6789, DOB 1/1/50."

By wording the beneficiary designation in this fashion, it will ensure that the lender only receives the amount they are due in order to pay back the outstanding loan at the date of death and not a penny more.  The residual death benefit would be paid to the named beneficiaries.  In some cases, this can also be spelled out within the collateral assignment form, but this will add an additional layer of security.