Life Insurance over the decades of evolution was considered to be an instrument for protection only. It was solely used to secure the uncertainties of tomorrow. However, now it has become a capital building instrument as well, just like many other investment tools. Some life insurance policies can be used as a collateral to raise a sum of loan as well.
What is “Pledging” of your Life Insurance Policy?
When the life insurance policy is used as a collateral or a guarantee for a loan, it is “pledged” as a security. Thus, loan against insurance policy is a secured form of loan and this process is called ‘pledging’. This loan can be provided by the policy issuance company itself or by any other institutions that provide such secured loans.
Benefits of Pledging a Life Insurance Policy
There are quite a few benefits of pledging your life insurance policy without actually breaking it, such as:
- Life Insurance Coverage Continues
When a life insurance policy is pledged, the coverage still continues and there is no need to break the policy. So, if the insured happens to die before repaying the entire loan, the policy would be surrendered to repay the outstanding amount and the rest would be paid to the nominee.
Once the entire loan is repaid as per schedule, the life insurance policy is transferred back to the policyholder.
- Acts as Collateral
Several lending institutions demands collateral to provide a loan against security and the insurance policy acts as one. So, if you pledge your life insurance policy as a collateral, you would not need not provide any other security.
- Interest Rate
The Interest Rates are lower when compared with the interest rates of the insecure loan like the personal loan. This is because loan against a life insurance policy is a secured loan.
- Loan Value
The Loan Value is decided as per the surrender value of the policy. So, higher the surrender value of the insurance policy, higher would be the loan payout.
- Value is Constant
Unlike the loan against gold or other instruments, the loan against an insurance policy value is not subject to market value fluctuations and is constant in nature.
The approval for loan is easily available as it is on the basis of the policy’s surrender value.
Thus, it makes sense to opt for a loan against a life insurance policy, rather than surrendering the same in order to meet your liquidity requirements for the short-term.
Factors to Consider While Opting for a Loan Against Life Insurance Policies
- Policies Acceptable for Loans
There are a wide range of Life Insurance Policies like the Term Plans, the Endowment Plans, the Whole Life Plans, the Money Back Plan, the ULIP Plans, the Return of Premium Plans etc. that are available in India. But all such categories of plans do not match the criteria to raising a loan.
For example, a term plan will not be considered as collateral as it is only to protect the loss of life of the insured and not build a corpus, against which a surrender value is available. Neither are all ULIP plans eligible to be pledged as its policy value keeps fluctuating as per the rise and fall of the stock market.
Thus, plans which have a guaranteed surrender value can be used to pledge for a loan. So, the acceptable criteria need to be checked before applying for a loan.
Also, the premium should have been paid regularly for a period of at least three years for the same to be used as collateral. However, these terms and conditions vary from lender to lender and needs to be checked before applying.
- The Amount of Loan Available
The amount that is generally sanctioned to the applicant is about 80% to 90% of the surrender value of a policy which guarantees a return. This also depends on multiple factors like total tenure, total insured amount, period of inforcement, etc. and is subject to approval.
- Transfer of Policy to Lender
Once a borrower pledges his policy to raise a loan he does not transfer the ownership to the lender. However, the policy is hypothecated to the lender till such time that the loan is repaid After the same has been done the loan amount is sanctioned.
Thus, if the interest that is due to be paid becomes more than the surrender value, the lender can surrender the policy to recover the loan. The borrower might lose the life coverage he is eligible for in the policy as its benefits have been hypothecated.
- Interest Rates
The rate of interest charged is inversely proportional to the number of premiums paid and the amount of the premium paid. A greater number of premiums paid will result in a lower interest rate charged.
- Documentation and Declarations
The policy issuance company will decide on the eligibility of the policy to acquire a loan after which the necessary approvals would be provided and documentation would be processed.
Now, since the policy would be hypothecated to the lender, the policy would thus be “assigned” to the lender till the loan amount is not repaid in full. The policy holder would need to give a declaration in the form of an assignment deed, as per the lending procedure and documentation of the lending company. This would result in transferring all the non-possessory benefits of the policy to the lender till the loan term would last.
- Policy Premium
The life insured needs to keep paying the premium for the policy even after it has been used as collateral or else the policy loses its benefit values and would get terminated.
- Tenure of Loan
The entire loan needs to be paid back within the policy term. If the borrower fails to pay back the principal in the stipulated time then the lender would settle the outstanding loan from the maturity amount.
- Claims in Case of Death of Policy Holder
In case of death of the insured within the loan, the lender would claim the outstanding l from the sum assured when the nominee would apply for his claim. After the deduction of the due loan outstanding, the remaining amount that would be left of the sum assured would be handed over to the nominee.
Loan is a good option provided to the policyholder in order to meet liquidity requirements as it is a secured loan and the continuity of the insurance policy is not disturbed. However, it might affect the financial planning of the policyholder and hence needs to be weighed.