Smart Move: Using Term Life Insurance for Business Loan Collateral

Most people overlook using term life insurance as collateral for a business loan start a business. Using term life insurance for a business loan helps reassure the bank a loan will be paid off while keeping your family protected from carrying the burden of any loan debt if something should happen to you. A collateral assignment of life insurance can help get you the nod of approval and keep you moving forward in starting your business.

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Rachael Brennan has been working in the insurance industry since 2006 when she began working as a licensed insurance representative for 21st Century Insurance, during which time she earned her Property and Casualty license in all 50 states. After several years she expanded her insurance expertise, earning her license in Health and AD&D insurance as well. She has worked for small health in...

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Benjamin Carr was a licensed insurance agent in Georgia and has two years' experience in life, health, property and casualty coverage. He has worked with State Farm and other risk management firms. He is also a strategic writer and editor with a background in branding, marketing, and quality assurance. He has been in military newsrooms — literally on the frontline of journalism.

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Reviewed by Benji Carr
Former Licensed Life Insurance Agent

UPDATED: Jul 19, 2021

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Starting and growing any type of business requires some degree of capital—for real estate, inventory, office equipment, the list goes on and on. Not too many business owners have enough in their bank accounts to cover those expenses.

The fact that you can use some types of term life insurance for business loan collateral is often overlooked. However, using term life insurance as collateral can have some pitfalls. This article will help you think through whether using term life insurance as collateral for a loan is the best source of funding for your venture.

Unfortunately, qualifying for a loan doesn’t always come easy. Banks are hesitant to make loans to new and unproven businesses unless they can ensure their investment is protected. And, in most cases, loans to new businesses must have some type of collateral to ensure their loan will be paid back.

Of course, business owners usually consider life insurance to protect their businesses. Having life insurance to reduce business risk can protect your business if anything were to happen to key personnel. But, many business owners don’t realize their existing life insurance policies can be a source of collateral.

If you buy life insurance for business loan collateral, it can help get you the nod of approval from lenders by giving them some assurance you won’t default on your payments.

Don’t have life insurance yet? Use our free quote tool and get an optimized and affordable life insurance quote in seconds and then read on to see how you can use your life insurance to get a business loan.

How Life Insurance is Used for Business Loans: Collateral Assignment

When you take out a loan, the bank that provides the loan creates a repayment plan that can spread out over a number of years. For the bank to make an investment into a new business, they will want to review your business plan and ensure that your business will make enough money to meet the repayment plan.

But what happens if a new business owner passes away before the loan is repaid? To protect the bank, prior to granting a loan, the bank may require that you assign as collateral the payout of a life insurance policy.

For term life insurance the bank will align the term of the policy with the term of the loan repayment. For instance, let’s say that you take out a $500,000/ 5-year loan to fund your business. The bank may require that you either purchase a new term policy or use an existing term policy for at least 5-years with a payout of at least $500,000.

It is important to understand that you are not putting the bank down as a beneficiary, but that you are assigning a payout to the bank if something were to happen. So, let’s say that you paid down $250,000. If you pass away before the remainder is paid, the $250,000 of the insurance payout will go to pay off the loan, and $250,000 will go to your beneficiary.

If you pursue this type of life insurance, you’ll need to sign a loan collateral assignment form to assign the bank as the recipient of the policy’s death benefit as long as the loan is in effect.

Usually, the bank will work with the insurance company to coordinate the execution of the form.

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What Types of Life Insurance Policies Work for a Collateral Assignment?

Both permanent and term life insurance policy types can be used for collateral assignment of a business loan. However, as a business owner, it will be much cheaper to pay term life insurance rates for business loan collateral than those for a permanent life insurance policy.

Of course, you might have an existing permanent life insurance policy in place. With a permanent insurance policy, you may have also built up considerable cash value. Using a policy with cash value can make it easier for a bank to make a loan decision.

How to Apply for Life Insurance for Collateral Assignment

When you apply for a business loan, a bank may have certain requirements before approving your loan. One of the requirements might be that you have a life insurance policy in place to collateralize the loan.

If you have an existing policy, the bank will work with your insurance company to complete the collateral assignment paperwork. If you don’t have a policy in place, the bank will work with your insurance company to write a term life policy for the number of years that it will take to repay the loan.

You will still need to go through the formal application process for your life insurance policy, as well as complete a medical exam. If you are denied approval for your policy, you will also be denied the loan.

Because of this, it can save you time by having a policy in place before you apply for a loan.

Absolute and Conditional Assignment

When you apply for a loan, your bank will determine whether you should assign a life insurance policy with an absolute assignment or conditional assignment. In most cases, the type of assignment depends on whether the policy was written in order to get the loan, or whether you had a policy in place already that you will use to collateralize the loan.

If you already had a loan, you will want to conditionally assign the loan to the bank for repayment during the term of the loan. After the loan is repaid, the bank will no longer have a claim for the benefit.

However, if you took out a loan for the specific purpose of collateralizing your loan, you will likely be required to absolutely assign the loan to the bank.

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Never Assign Your Bank as the Beneficiary

Remember, the bank is not a beneficiary of the policy, so do not assign them as a beneficiary. They will have a claim to the payout proceeds of the policy in the event of the death of the policyholder prior to the full loan repayment.

The last thing you want is for the bank to have a rightful claim as a beneficiary of the policy. This is because when a beneficiary is paid out, they are entitled to a percentage of the policy.  For a collateral loan assignment, you want the bank only to hold entitlement to the amount of the loan that is outstanding.

So, if a policyholder pays off more of the loan but dies during the term, the policyholder’s family will want to make sure the bank only gets the amount to pay off the remainder of the loan.

A Few Tips to Help You Get the Right Policy

  1. Inform your agent or broker upfront that you need the policy as loan collateral. That way, they’ll know to prepare for the extra paperwork involved.
  2. Take out a term life policy that’s long enough to cover the loan repayment period. For example, if you’re getting a 20-year business mortgage loan, you will need a 20-year term life insurance policy.
  3. Don’t drag your feet! Because most lenders won’t finalize a loan until you’re able to show “proof of policy,” don’t wait until the last minute to talk with a life insurance agent if you don’t already have a policy. On average, it takes four weeks for policy approval. If you have medical conditions, the review process could take longer. Your bank may not want to wait that long.

Note that you can expedite the process of securing life insurance if you opt to apply for a no medical exam term life insurance policy. By going that route, you won’t have to take the paramedical examination otherwise required (if you do have to take the examination, understand what to expect from a life insurance medical exam here). These types of policies generally receive approval in 24 to 48 hours. The drawback is that they cost a bit more because the insurer is assuming more risk.

When to fill out collateral assignment paperwork

If you are looking to secure a loan by using a life insurance policy, you will need a policy in place first. The bank will want to make sure that you are in good health and can qualify for a policy.

Once you have a policy in place, the bank will review the rest of your loan application. If they choose to provide you a loan, the bank will then work with your insurance company to produce the assignment paperwork.

So, until you know that your loan will be approved and your policy is in place, you don’t need to worry about assigning the policy.

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When does a collateral assignment end?

A collateral assignment will end when the loan is repaid. It’s as simple as that. However, the amount that the bank can claim reduces as you repay your loan.

So, if you took out a loan of $500,000 for a 10-year period, in the last year, the bank wouldn’t be able to claim $500,000 against the policy, but instead would discount the claim for the amount of principal that was repaid against the loan.

Pros & Cons of Collateral Assignments

Collateral assignment to secure a business loan does have benefits and disadvantages.
Pros:

  • Term life insurance used to secure the loan is inexpensive. And as you pay off the loan, your family has an additional source of security.
  • Using the insurance policy as a way to collateralize your loan allows you to free up other assets and cash flows to run your business.

Cons:

  • If you have a permanent insurance policy, your access to use the cash value in the plan will be limited until the loan is repaid.
  • Until you repay the loan, you may need additional life insurance to secure your family in addition to the policy used to secure your business.

In the end, however, most banks will require you to secure your loan with a policy. Keeping in good health and securing a policy while you are younger will help you qualify for the lowest rates. Check out the rates below to get an idea of how much you might pay for a simple term life policy.

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Average Monthly Life Insurance Rates by Age
AgeAverage Monthly Rates for a Male, $100,000 PolicyAverage Monthly Rates for a Female, $100,000 PolicyAverage Monthly Rates for a Male, $250,000 PolicyAverage Monthly Rates for a Female, $250,000 PolicyAverage Monthly Rates for a Male, $500,000 PolicyAverage Monthly Rates for a Female, $500,000 Policy
25$11.03$10.02$22.10$12.91$23.19$19.04
30$11.12$10.07$15.31$13.02$23.85$19.26
35$11.12$10.07$15.42$13.02$24.07$19.26
40$12.65$11.12$17.94$15.21$29.10$23.63
45$14.57$13.31$21.55$19.69$36.32$32.60
50$18.60$17.20$30.19$27.02$53.60$47.26
55$24.51$20.61$42.88$34.35$78.98$61.91
60$35.88$27.48$71.10$50.86$78.98$94.94
65$51.06$37.76$109.82$75.14$212.85$143.51
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One last benefit is that your premium payments are an expense to the business and are tax-deductible.

Alternatives to Collateral Assignment

In some cases, you won’t have much of a choice but to take out an insurance policy to secure your loan. The bank will insist upon it.

However, you won’t have to if you use some other collateral for the loan. This could be real estate that you own, financial securities like stock and bonds, or simply a cash account with the amount available.

However, in each of these instances, you will lose the flexibility in managing these assets since you will have to hold on to them for the life of the loan.  Also, you will need to manage the value of these assets. If they decrease in value, the bank may insist that you come up with additional capital.

If you are struggling to find a bank to provide you with capital, you can reach out to the U.S. Small Business Administration for helpful guidance on funding options.

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Using Term Life Insurance as Collateral for a Loan: The Bottom Line

If you have dreams for your business and you need funding to help them come true, keep the option of a term life policy as loan collateral in mind as you talk with lenders.

Because of its affordability and flexibility, term life insurance can give the bank the assurance it requires without putting undue strain on your business budget.

The first step is to have a great policy in place at the best price. Start shopping right now by using our free quote generator. Get a custom term life insurance quote for business loan collateral in seconds and save time with the loan process later.

References:

  1. https://www.sba.gov/business-guide/plan-your-business/fund-your-business

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