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How to use life insurance to cover your debt
Can a life insurance policy be used to pay off debt?
Yes, the death benefit from a life insurance policy can be used to pay off debt. In fact, it’s one of the many reasons why people buy life insurance. If they were to die unexpectedly, they don’t want to leave behind debt that their loved ones need to worry about.
A good rule of thumb is to buy life insurance with a term that lasts the length of your largest source of debt. This is usually your mortgage.
Even if you don’t personally have too much debt, your beneficiaries can use the death benefit however they wish. If they have their own personal debt, the death benefit can be used to pay this off as well.
Purchasing a permanent life insurance policy that builds cash value can also be used to pay off debt. If you buy a permanent life insurance policy that is designed to accumulate cash value, like a whole life insurance policy, you can borrow against it or withdraw funds. These funds can be used however you wish, including paying off debts.
What kind of debt can get paid off with life insurance?
Any kind of debt can be paid off with the death benefit from a life insurance policy. Americans have developed, out of necessity, an increased comfort level with holding debt.
Individuals are now borrowing more over a lifetime in the form of:
- Student loans
- Auto loans
- Credit cards
- Home equity loans
- Home equity lines of credit
- Reverse mortgages
Do you carry any of these types of debt? If you die without paying off the balances, life insurance can help your loved ones pay these responsibilities without going into debt themselves.
Can creditors go after life insurance?
In most cases, the death benefit of a life insurance policy passes to your beneficiaries outside the reach of your creditors. The main thing you need to do so the life insurance is exempt from your creditors is to name an individual beneficiary.
If you do not name any beneficiaries, the life insurance reverts back into your estate. Estates go through a court process called probate. During probate, creditors would be able to access the life insurance proceeds.
Be sure to name contingent, or back up, beneficiaries as well. Should your primary beneficiary predecease you or die at the same time as you, the death benefit would revert back to your estate in this situation if there are no named contingent beneficiaries.
If you name the appropriate beneficiaries to keep the life insurance out of your estate, it’s safe from your creditors. However, once your beneficiaries receive the death benefit nothing stops your beneficiary’s creditors from accessing it.
Spendthrift clauses and trusts is one way to protect the death benefit from your beneficiary’s creditors.
A spendthrift clause can be set up in the life insurance policy. With this provision in place, the death benefit is paid to the insurance company instead of directly to the beneficiary. Thereby keeping it out of the creditor’s reach. The insurance company then pays out the death benefit proceeds as periodic income rather than the typical lump sum.
Naming a trust the beneficiary of a life insurance policy is another way to protect the death benefit from your heir’s creditors. Because the trust is the life insurance beneficiary, it keeps the death benefit out of the reach of the creditors. A trustee manages the death benefit funds and pays your heirs according to the instructions you leave in the trust. Many different types of trusts can be set up with this spendthrift provision.
Common Questions About Using Life Insurance to Pay Debt
Calculate how much life insurance you need to pay off your debt
Buy enough term life insurance to ensure your loved ones can pay off your debt if you die. Quotacy’s life insurance calculator helps you decide how much life insurance coverage you need to leave your family financially secure.
Learn more: How Much Life Insurance Coverage Do I Need?
Learn more: How Long Should My Life Insurance Last?
Cover your mortgage payment with life insurance
If you died who would pay your mortgage? Can your surviving loved ones keep up with payments without your income? Term life insurance can cover your payments so that your family isn’t forced to move. Buy enough term life insurance coverage to pay off your mortgage. And purchase a term length at least the length of the mortgage loan.
Learn more: Term Life Insurance for Homeowners
Cover your child's education expenses with life insurance
If you plan on contributing to your children’s college education, you can buy enough life insurance to cover the costs. A good education can help your children take care of themselves well into the future.
If your children are young and they go to a private school, life insurance can help pay for this tuition as well should you die unexpectedly. During a stressful time such as the death of a parent, being able to let your child stay at their same school may be very beneficial.
Learn more: College and Life Insurance
Cover your co-signed debt with life insurance
If you have debt that is co-signed, the co-signer becomes responsible for the remainder of the balance if you die before the debt is paid off. Term life insurance can protect the co-signer of your student loan, home mortgage, or credit card debt, among other types of debt. You, the borrower, can purchase term life insurance on yourself and name your co-signer as a beneficiary or your co-signer can own a life insurance policy on you, the borrower.
Learn more: Term Life Insurance for Cosigners
Cover your business debt with life insurance
Term life insurance can be used to cover your small business loans. If you, the business owner, die your family may be responsible for repaying your loan. Life insurance mitigates this risk by providing your family with money for the years remaining on your loan.
Life insurance can also be used to fund a buy-sell agreement. At your death, a buy-sell agreement can ensure your share of the company stays with the company. The death benefit from the life insurance policy on your life can be used to purchase your share from your estate.
Cover your final expenses with life insurance
Your final expenses may include your funeral, burial, medical bills, or estate expenses. An unexpected death can create financial disaster for your loved ones. A term life insurance policy protects your family’s standard of living and covers the costs associated with a funeral and burial if you die unexpectedly.
Learn more: Plan Ahead for Your Final Expenses
Read our buyer's guide for term life insurance
Term life insurance can replace your earned income until your family has saved enough money to cover monthly expenses or loan repayment on your student loans, home mortgage, or credit cards. Choose your life insurance term length and coverage amount based on how much debt you wish to cover or how much earned income you need to replace.
Learn more: Term Life Insurance Buyer’s Guide
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