A life insurance collateral assignment can strengthen your borrowing power, but it could also leave your family more exposed financially if you died unexpectedly.
Before making a collateral assignment, take a few minutes to consider how the decision could affect everyone involved.
By finding the right balance, you can benefit from the collateral assignment while still using life insurance for its primary purpose.
Collateral Assignments and Life Insurance
A collateral assignment helps you leverage your life insurance policy as collateral for a loan.
If you assign part of your life insurance death benefit to your lender rather than your beneficiary, your coverage could pay off your loan if you died.
Collateral assignments are often used by small business owners to protect themselves and their business.
You could also assign as collateral the cash value portion of a whole life policy in case you defaulted on the loan.
Term Life Collateral Assignment
A term life collateral assignment lets your lender access only the policy’s death benefit which would ordinarily go to your beneficiary if you died with the coverage in force.
Term policies last for a specific amount of time, usually ranging from 10 to 30 years.
If your term policy expired before you paid off the loan, you’d have to make other arrangements for collateral.
Because term life coverage is not permanent, and because term policies have no value beyond the death benefit itself, they can usually offer you more coverage at a lower premium.
Whole Life Collateral Assignment
Unlike a term life policy, a whole life policy will slowly accrue cash value in addition to the level of death benefit.
This cash value could help secure your loan by serving as collateral in case you default on the loan. Assigning cash value as collateral works only if the policy has already accrued enough value.
Cash value builds slowly, so a new whole life policy wouldn’t have much-added value to your lender.
Because of its cash value component and the permanence of its coverage, a whole life policy tends to cost significantly more than a term life policy.
Collateral Assignment Pros & Cons
If you’re applying for a large business loan and need, for example, $150,000 worth of collateral to finalize the loan, your loan officer may suggest a few options.
You could use your home or other real estate holdings as collateral. You could also use investments or your shares in another business.
There’s a good chance the loan officer will also mention life insurance collateral assignment as a possibility.
Pros of Collateral Assignment
Using a life insurance policy as collateral appeals to loan applicants for a variety of reasons:
- Flexibility: Using a life insurance collateral assignment instead of real property allows you to sell your real property if needed. Selling your home would have implications on your business loan if the home were listed as collateral. Likewise, if you defaulted on the loan, your lender could possibly claim your home.
- Affordability: Depending on your age and health, you could get a large amount of term life insurance coverage for a low premium. A premium of $35 a month for a term policy, for example, could allow you to leverage $500,000 in term life coverage. (Life coverage is highly individualized; your premiums could be much different.)
- Elegance: Using life insurance coverage as collateral strikes many borrowers as an elegant solution because the life insurance death benefit wouldn’t exist unless you died. In other words, the problem (non-payment because of death) would create the solution (death benefit from life insurance to repay the loan).
Cons of Collateral Assignment
Despite its strong points and its popularity, a collateral assignment can also have some drawbacks:
- Limited Death Benefit: Your beneficiary couldn’t claim your death benefit if you’ve assigned it to a lender. It’s best to assign only a portion of your benefit as collateral or to get a separate policy specifically for the collateral assignment.
- Effort to Get Insured: Recent advances in underwriting have quickened the process, but getting quality and affordable life insurance can still take a few weeks, especially when you want medically underwritten coverage which requires a medical exam but also offers lower premiums if you’re healthy.
- Loss of Policy Control: Until you pay off the loan, you’ll need to keep the life insurance policy active. If you don’t, your lender could buy another policy for you and add the premiums to your loan’s principal.
- Limited Use of Cash Value: The cash value component of a whole life policy can be useful later in life. In some policies the cash value can eventually subsidize your premiums, making coverage more affordable. In others, your cash value can be tied to an investment index. Using the cash value as collateral limits your policy’s flexibility.
Best Times to Use a Collateral Assignment
A collateral assignment can be a powerful tool, especially for a business loan applicant who wouldn’t otherwise have the borrowing power needed to get a loan.
Like most financial tools, collateral assignment works better in some circumstances than in others. Here are some optimal times to leverage your life insurance policy as collateral:
When You Have Extra Coverage
Different phases of life usually call for different levels of insurance coverage. Someone with a young family and a new mortgage may need $1 million or more to feel secure about the family’s finances if the worst happened.
Twenty years later, with the house paid off and the children grown, $200,000 in coverage may be enough. In that case, the policyholder could more easily afford a collateral assignment without worrying about losing coverage.
When You Get a New Policy
If you have just enough insurance to protect your family but you’d like to make a collateral assignment, consider getting a new policy specifically for the loan’s collateral.
Along with keeping your family’s life insurance protection intact, you can also design the new policy’s coverage amount and term length specifically to match the loan.
A 10-year term policy would be enough if you expect to have the loan paid off within 10 years.
Even though you’re getting the new policy for collateral assignment, you should never name your lender as your beneficiary. Instead, name a family member as your beneficiary then make the collateral assignment.
If your lender is the beneficiary, the bank could claim all of your death benefits, even if the benefit exceeds the balance of your loan. An assignment gives the lender access to only the loan’s balance.
When You Couldn’t Otherwise Borrow
Some business lenders require life insurance as collateral to protect the loan. Other times, a borrower doesn’t have other forms of collateral to put up.
In such cases, a collateral assignment may be your only option if you want to secure the loan.
How to Make a Collateral Assignment
A collateral assignment is easy enough to arrange.
If you have a policy and would like to assign part of its death benefit or cash value as collateral, ask your life insurance company to mail you a collateral assignment form or look for a form on your insurer’s web site.
Collateral assignment forms tend to be simple. Insurance companies are not actively interested in whether you assign part of your death benefit or cash value to a third party.
If you don’t already have life insurance coverage, or if you’d like separate coverage for collateral assignment, you’ll need to shop around for the right kind of coverage.
Quick Guide to Life Insurance
It’s easier than ever to find good life insurance coverage online with more and more agencies and insurers competing to provide you coverage. You can get quotes on this page and start the shopping process.
Since you’re buying a policy specifically for collateral assignment, you can design your new coverage to meet your lender’s needs:
- Coverage amount: You can match your coverage amount on the new policy to the amount you need in collateral — or you can buy more coverage and assign only part of the benefit to your lender.
- Type of policy: A term life policy will usually cost less than a comparable amount of coverage in a whole life policy. If you need a smaller amount of coverage or have medical conditions that could limit your options, a no-exam policy may work. Be sure to get enough coverage to meet the bank’s collateral requirements.
- Choosing a beneficiary: You should never list your lender as the beneficiary of your life insurance policy. If you do, the lender could receive all of your coverage and not just the loan balance.
- Quality of coverage: Independent rating agencies can help you assess the health of an insurance company before you buy coverage. Look up a company’s A.M. Best or Moody’s ratings before buying. We can help with this if you need it.
Making (and Ending) the Collateral Assignment
Before buying a policy, make sure the company will allow a collateral assignment. Most companies have no problems allowing you to assign part of your death benefit or your cash value. It never hurts to make sure, though.
Your lender will have the most active interest in the collateral assignment process.
The bank or credit union will likely want to receive copies of all your correspondence with the insurance company so they’ll know about changes to your policy and its assignment.
The lender may also require you to get the form notarized after all parties have signed it. When you’ve paid off your loan, the lender’s assignment should expire automatically.
You can always check with your insurance company to make sure your beneficiary is once again the sole recipient of your benefits.
A collateral assignment is one of many ways life insurance can provide affordable answers to financial questions. Contact us if you have any questions.