Risks of an IFA
There are several potential risks to be aware of when leveraging a life insurance policy for personal or business purposes. Some of the potential risks include the following:
Insufficient coverage: It's important to ensure that the life insurance policy provides sufficient coverage to meet your needs. Leveraging the policy is pledging part of, if not all, of the death benefit of the policy. If the policy does not provide enough coverage, it may not be able to fully protect your loved ones or your business in the event of your death after paying off the 3rd party loan.
Policy lapse: If you are using a life insurance policy as collateral for a loan, it's important to keep the policy in force by paying premiums on time. If the policy lapses or is cancelled, you could lose the coverage and the financial protection it provides. At that point, you would be required to repay the loan back to the lender out of pocket. This strategy works well when there is a future liquidation event on the horizon which would allow the ability to repay the loan.
Interest Rate Risk: If you are using a life insurance policy as collateral for a loan, you must be aware of the effects interest rates have on your loan. The amount of interest paid every year can rise, which puts strain on the cash flow of the business or person. If the interest is being added every year to the loan balance, you must make sure that the loan balance is not growing at a rate faster than the insurance policy is growing, so you have enough money on death to pay off the loan.
Policy structure: It's important to carefully review the terms and conditions of your life insurance policy before using it as collateral for a loan or other financial arrangement. Ensure you understand how the policy works and what projections have been assumed. There may be issues down the road that make your policy perform differently than when this strategy starts. Regular maintenance of the IFA is important to ensure this strategy is still performing as projected.
Policy ownership: There is a lot of complexity when it comes to ownership of the policy and ownership of the loan. Make sure that these policies are being looked at by an insurance specialist who deals in this space. These policies need to be set up correctly to avoid major tax problems down the road. There are also special instructions that need to be followed when it comes to how the loan is paid off in certain circumstances. Makes sure you are working with a specialist in this area, so it is done correctly.
It's important to carefully consider the potential risks and limitations of leveraging a life insurance policy before making a decision. In many cases, it may be advisable to seek the guidance of a financial advisor or other professional to help evaluate the potential risks and benefits of using a life insurance policy in this way.
