Collateral assignment of life insurance means using a policy as collateral for a loan. If the borrower dies before paying it back, the lender can take the unpaid amount from the insurance payout upon the borrower’s death.
In this guide, you’ll learn how collateral assignments work, why they’re used, and the pros and cons of using life insurance as collateral.
Table of Contents
- What Is Collateral Assignment?
- Policy Options for Collateral Assignment
- How to Use Life Insurance as Collateral for a Loan
- Life Insurance as Collateral: Pros & Cons
- Alternatives to Life Insurance
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What Is Collateral Assignment?
Valuable assets (like a home or vehicle) typically serve as collateral for a mortgage or an auto loan. If you default on payments, the lender can repossess it to recover their money.
Lenders require reassurance for loans that aren’t directly tied to a physical asset. You can use a life insurance policy as loan collateral in these cases.
As owner of the life insurance policy, you collaterally assign it to the lender, which means:
- If you die before the loan is repaid, the death benefit covers your remaining loan balance
- Any remaining proceeds go to your named beneficiaries
Collateral vs Absolute Assignment of Life Insurance
There are two types of assignment for life insurance: collateral and absolute.
Collateral assignment of life insurance: You control the policy. It’s commonly used to secure a small business loan.
Absolute assignment: You transfer all policy rights to the assignee. It’s often used when a policy owner sells it to a third party for an immediate cash benefit.
Similarities between collateral and absolute assignment:
- Both involve the transfer of rights under a policy.
- Both require the consent of the insurance company.
- Both can be used as a means of managing financial risks or responsibilities.
Differences between collateral and absolute assignment:
- Used to secure a loan or other financial obligation.
- The policy owner maintains ownership and control over the asset, except for the rights assigned as collateral.
- The lender (assignee) only has rights to the asset in the event of death or, in some cases, default.
- The assignment is temporary and removed when the loan is repaid.
- The policy is fully transferred to a new owner.
- The original owner gives up all rights and control over the policy, including the right to name beneficiaries and access cash value.
- The new owner can manage the policy however they see fit, including selling it, borrowing against it, or changing its terms.
- The assignment is permanent; the original owner can’t reclaim rights to the policy without the new owner’s consent.
Life Insurance Assignee vs Beneficiary
A life insurance assignee is a person or entity to whom a policy’s rights have been transferred.
A beneficiary is a person, trust, or entity designated by a policy owner to receive the death benefit when the insured person dies.
Whether used for collateral assignment or not, your policy needs designated beneficiaries.
- The lender only has a legal claim to the death benefit if you die before the loan is paid.
- If you pass away, the lender gets their payment, and the rest goes to your beneficiaries.
- If you repay the loan in full and die, the lender receives nothing, and your beneficiaries receive the full benefit.
Life Insurance Policy Options for Collateral Assignment
Using life insurance for collateral assignment when applying for loans is a common practice that almost every life insurance company and lender is equipped to handle.
Examples of when life insurance can be collaterally assigned include:
- Personal loans
- Business loans
- SBA loans
There are two types of life insurance—term life insurance and permanent life insurance—and both kinds can be used for collateral assignment.
Term Life Insurance
Lenders typically accept term life insurance as collateral, provided that the policy aligns with the size and duration of the loan.
Coverage and term length must equal the loan’s terms– or exceed them.
For example, if you’re securing a 20-year loan, you would need a term life insurance policy that spans 20 years.
If you pass away before repayment, the insurance company pays the outstanding loan balance to the lender from your policy’s death benefit first. Any remaining amount after the loan is fully paid would then be distributed to the beneficiaries you have named on your policy.
If you repay the loan before passing, the collateral assignment ends, and the total death benefit amount is reserved for your beneficiaries.
Permanent Life Insurance
Lenders often find permanent life insurance policies appealing as collateral due to their unique cash value component.
Life insurance with cash value provides an added level of reassurance to the lender, ensuring the cash value will offset the loan if the borrower defaults.
However, even though the policy’s worth grows over time, the death benefit must cover the entire loan.
If you pass away before the loan is repaid, the company would first pay the loan balance from your policy’s death benefit to the lender.
Any remaining proceeds from the death benefit would then be distributed to the beneficiaries named on your policy.
Learn more about the differences between term and permanent life insurance.
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How to Use Life Insurance as Collateral for a Loan
If you’re looking to secure a loan with life insurance, you can buy a policy to do so or collaterally assign a policy you already own.
Collateral Assignment of a Life Insurance Policy You Already Own
To collaterally assign an existing policy, you and your lender must fill out a short form confirming the details.
You or your agent can request this form directly from the life insurance company.
Once the completed forms are back in the insurance company’s possession, they will review them and send confirmation in a few weeks.
- If you already own a life insurance policy worth enough to cover the loan, you can usually use it as collateral.
- If you currently have term life insurance, the remaining years on your term must be longer than the loan’s term.
Collateral Assignment of a New Life Insurance Policy
Buying a new life insurance policy for collateral assignment is similar to that of any other purpose for life insurance.
- Step 1: Determine the amount of life insurance coverage you need. While the coverage should be sufficient to cover the loan, you may consider additional obligations like income replacement for your family, mortgage payments, and more.
- Step 2: Apply for a life insurance policy as you would normally. List your chosen beneficiaries, such as your spouse, adult child, etc. At this stage, there’s no need to list the lender as a beneficiary.
- Step 3: Activate your policy. Then, request a collateral assignment form from your agent or insurer directly.
- Step 4: Complete the form and return it to the insurance company. After processing, the insurer acknowledges the collateral assignment. Then the lender obtains rights to the death benefit, up to the amount owed on the loan, if you die before the loan is repaid. Any remaining death benefit would be distributed to the other named beneficiaries.
- Step 5: While collateral assignment is active, policy control may be limited. The specifics of what actions are permissible can vary, so reviewing the terms of the loan and collateral assignment agreement is essential.
- Step 6: Collateral assignment terminates when the loan is paid. Your full ownership rights are then restored.
Explore the various ways business owners use life insurance to protect their business and their loved ones.
Life Insurance as Collateral: Pros and Cons
Overall, using life insurance as collateral can be a sound and effective strategy for obtaining a loan, provided that it aligns with your financial circumstances and goals.
Collateral assignment impacts your control and financial protection for beneficiaries positively and negatively.
- Access to loans
- Loan approval
- Protection for beneficiaries
- Limited policy control
- Risk to beneficiaries
- Additional costs
- Policy loss
Alternatives to Collateral Assignment
Collateral assignment isn’t the only way to secure a loan. Knowing alternatives can help you decide what best aligns with your financial circumstances and goals.
Some examples include:
- Cash value: If you already own a permanent life insurance policy with accumulated cash value, you can borrow against this amount through policy loans.
- Unsecured loans: These do not require collateral and are primarily based on your creditworthiness. They often come with higher interest rates.
- Secured loans: These are backed by collateral that isn’t life insurance, like investments, savings accounts, or valuable property. If you default on a secured loan, the lender seizes the collateral.
- Home Equity Line of Credit (HELOC): This uses your home as collateral if you’ve built enough equity.
- Credit cards: Interest rates are higher than other loans, but credit cards can be used in a pinch.
- Grants or government programs: Grants or government programs might be available to provide funds with attractive terms.
Compare Life Insurance Quotes and Apply Today
The primary purpose of life insurance is to provide financial protection to those who depend on you. But life insurance has other uses as well, such as collateral assignment.
If you don’t yet have life insurance, start by getting quotes. Here at Quotacy, you can see quotes instantly without giving away any contact information. Compare policies from multiple top-rated insurers and apply with confidence.
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