The Pros and Cons of Cashing Out Your Life Insurance to Pay Debts

In 2012, the average American had just under $16,000 in credit card debt alone. This is a startling figure, considering this number does not include other types of large debt, such as student loan debt, mortgages, or car loans. The financial landscape for the average American seems to be bleak.

Some people have different financial vehicles in place that can help them with their outstanding debt in a number of ways. One such flexible product is whole life insurance. These policies not only provide a death benefit upon the death of the policyholder, they also have a financial investment portion built in that helps the policy to gain cash value. This cash value can be tapped into at certain times, such as to pay off debts. Three pros and cons to cashing out your life insurance to pay debts are:

Take a Loan Instead of Cashing Out

Pro: You can take out a loan against your policy that will keep the policy intact but give you the funds you need. Rather than cashing out your life insurance policy, you can take out a loan against the cash value instead. This way, you can repay the loan and still have a policy that is in effect in the event of your death. You can use your loan proceeds to pay down your debts and then tackle repaying the loan to the insurance policy.

Con: if you do not pay the loan back, the death benefit will be reduced by the amount you borrow Repaying the loan is not mandatory and you could decide not to make payments back into the account. If you choose to do this, however, the amount of the death benefit your survivors will receive upon your death will be reduced by the loan amount. Also, if you do not pay the interest on the loan, it can continue to accrue until there is a negative cash value in the loan and you will have to pay a large amount to make it current.

Cash Out and Pay Debts Off

Pro: You can cash out your policy completely and pay off debts so that your survivors do not have to pay them after your death.  If you pay off all your debt with the proceeds from cashing out your insurance policy, and do not accrue new debt, there will be no debt for your survivors to pay back after your death. Depending on the circumstances of your beneficiaries, this may eliminate your need for life insurance.

Con: A portion of the cashed out value may be considered taxable income, you may have to pay taxes on a portion of the cashed out proceeds, if you are given money more than the amount of the premiums you paid, this is taxable income.

A Loan Does not Have to be Paid Back

Pro: You can borrow the money against your policy and then not have the stress of paying it back. A loan against your life insurance policy will be granted for any reason, without a credit check, and the interest rate will be lower than that of a traditional loan. You can pay back the loan on your own terms, but will not incur a penalty if you decide not to make repayments. If you do repay the loan and the interest, back into your policy, your death benefit will remain at the level where it was previously stated to be.

Con: If you do not pay the loan back, the death benefit will be reduced by that amount and your survivors will have to pay remaining debt with a reduced payout. It is difficult to pay off debt and not incur any other debt in its place. If you create more debt after your debts are paid off with a loan against your life insurance policy, your survivors will have to repay this debt with whatever death benefit they get from your life insurance policy. If you take out a loan and do not repay it, that death benefit will be reduced and they will likely not have any money left over after paying the new debts.

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