What is collateral assignment?

Collateral assignment: When you pledge your life insurance contract as security for a loan, you give the lender the right to collect from the policy’s cash value or death benefit in two circumstances. One is when you stop making payments; The other is if you die before the loan is repaid. Backing a loan with life insurance reduces the lender’s risk, which improves your chances of getting a loan on the loan.

Before proceeding with collateral assignment, it is important to understand how the process works, how it affects your policy, and possible alternatives.

What is life insurance: Complete guide on life insurance

Collateral Assignment Definition and Examples

Collateral assignment is the practice of using life insurance as collateral for a loan. Collateral is any asset that your lender can hold if you default on the loan.

For example, you can apply for a $25,000 loan to start a business. However, your lender is not willing to approve the loan without sufficient collateral. If you have permanent life insurance with a cash value of $40,000 and a death benefit of $300,000, you can use that life insurance to secure the loan. By assigning collateral for your policy, you authorize the insurance company to give the lender the amount you owe if you are unable to keep up with payments (or if you die before the loan is repaid).

Lenders have two options for cashing under a collateral allocation agreement:

1. If you die, the lender gets a portion of the death benefit—up to your remaining loan balance.
2. With permanent insurance policies, the lender can give up your life insurance to access the monetary value if you stop making payments.

How Collateral  Assignment Works

Whenever lenders approve a loan, they cannot be sure that you will repay it. Your credit rating is an indicator, but sometimes lenders want extra security. Also, surprises happen, and even those with the strongest credit profiles can die unexpectedly.

Assigning life insurance as collateral gives lenders another way to protect their interests and can make approval easier for borrowers.

Types of life insurance collateral

Life insurance can be divided into two broad categories: permanent insurance and term insurance . You can use either type of insurance for a collateral assignment, but lenders may prefer permanent insurance.

• Perpetual insurance : Perpetual insurance, such as universal and life insurance, is a lifetime insurance coverage that contains a cash value. If you default on the loan, lenders can surrender your policy and use that cash value to pay off the balance. If you die, the lender is entitled to the death benefit up to the amount you still owe.
• Term insurance : Term insurance provides a death benefit, but it is limited to a certain number of years (e.g. 20 or 30 years). Since these policies have no cash value, they only protect your lender if you die before paying off the debt. The term of a term policy used as collateral must be at least as long as your loan term.

A note on pensions

You may also be able to use an annuity as collateral for a bank loan. The process is similar to using life insurance, but there is one key difference you need to be aware of. Any amount assigned as security for an annuity is treated as a distribution for tax purposes. In other words, the amount allocated will be taxed as income up to the amount of contract gain and may be subject to an additional 10% tax if you are under 59½.

The process

In order to use life insurance as collateral, the lender must be willing to accept a pledge of collateral. In this case, the policyholder or “assignee” sends the insurance company a form to make the agreement. This form contains information about the lender or “assignee” and details the lender’s and borrower’s rights.

Policy owners generally have control over policies. You can cancel or surrender coverage, change beneficiaries, or assign the contract as security. However, if the policy has an irrevocable beneficiary, that beneficiary must approve the assignment of collateral.

State laws usually require you to notify the insurer that you intend to pledge your insurance policy as security, and you must do so in writing. In practice, most insurers have specific forms detailing the terms of your order.

Lenders get paid first

If you die and the policy pays a death benefit , the lender gets the amount you owe first. Your beneficiaries will receive any remaining funds once the lender is paid. In other words, your lender takes precedence over your beneficiaries when using this strategy. Be sure to consider the impact on your beneficiaries before completing a collateral assignment.

After you repay your loan, your lender has no right to your life insurance, and you can request that the lender release the assignment. Your life insurance company should have a form for this. However, if a lender pays premiums to keep your policy in effect, the lender can add those premium payments (plus interest) to your total debt – and collect that extra money.

Alternatives to Collateral Assignment

There are several other ways you can get loan approval – with or without life insurance:

• Give up a policy : If you have cash value life insurance that you no longer need, you might be able to give up the policy and use the cash value. This could eliminate the need to borrow, or you could borrow significantly less. However, if you surrender a policy, your coverage will end, meaning your beneficiaries will not receive a death benefit. Also, you probably owe taxes on winnings.
• Borrow from your policy : You may be able to borrow against the cash value of your perpetual life insurance to get the funds you need. This approach could eliminate the need to work with a traditional lender and creditworthiness would not be an issue. Borrowing can be risky, however, as an unpaid loan balance reduces the amount your beneficiaries receive. Additionally, over time, deductions for insurance costs and compound interest can negate your present value and the policy may expire. Therefore, monitoring is crucial.
• Consider Other Solutions : You may have other options unrelated to life insurance. For example, you could use the equity in your home as collateral for a loan, but you could lose your home in foreclosure if you can’t make the payments. A co-signer could also help you qualify, although the co-signer takes a significant risk by guaranteeing your loan.