What Is Collateral Assignment of Life Insurance?

If you'd like to borrow money through a loan, life insurance could help you qualify and get a lower interest rate. Through something called a collateral assignment of life insurance, you can set up an agreement where your policy pays the lender in case you can't.

Not every lender accepts this arrangement, and there are downsides, notably that your primary beneficiary is no longer first in line for the life insurance death benefit. However, in the right situation, it can be a useful financial strategy. Here's what to know about an assignment of life insurance and how to use it properly.

What Is Collateral?

Collateral is a valuable asset that can be used to secure a loan. When you borrow money, you legally agree to repay the lender, usually with scheduled payments and interest. But the lender is taking a risk that you won't pay them back.

When you put up collateral, the lender can legally take that asset if you don't pay back the debt. Real estate, vehicles, equipment and investment accounts are common examples of loan collateral.

What Is the Collateral Assignment of Life Insurance?

In a collateral assignment of life insurance, you use a life insurance policy to secure a loan. You first set up coverage as usual by applying for and buying some type of life insurance policy with a death benefit. If you already have a policy, you could use that too.

Then you fill out a collateral assignment form with the lender. This gives them the right to use the life insurance benefits to pay themselves back if you don't pay off their loan. This could happen if you default or if you happen to die before paying off the debt. With this assignment, you've agreed to use the life insurance death benefit to pay off the remaining loan balance first.

You'll still select a primary beneficiary, the person or entity you want to receive the insurance payout. But with a collateral assignment, if you die without paying off the loan, the life insurance death benefit pays off the debt first. Only if there's any remaining benefit amount does it go to your listed beneficiary. Once you pay off the debt, the assignment ends, and the life insurance would pay your beneficiary in full as usual.

Can You Use Any Type of Life Insurance?

It depends on what the lender is willing to accept. In theory, you could use any type of life insurance for this arrangement. However, some lenders may only accept permanent coverage, such as whole life or universal life. The reason is that permanent coverage doesn't expire as long as you or the lender make the premium payments. As a result, the lender can make sure they eventually collect the death benefit by making the premium payments themselves (they would add this cost to your outstanding debt). Another reason lenders may prefer permanent life insurance is because it can build cash value, a reserve of money while you're alive. This is another valuable asset the lender could take as repayment.

On the other hand, term life insurance has a set expiration date. If you outlive the term, the coverage ends. While a lender could accept term life insurance as collateral, they take on the risk that you both fail to pay off the loan and outlive the term. In this case, the lender would lose their collateral and won't be certain to get their money back.

What Are Some Examples Using Life Insurance as Collateral?

Hypothetical scenarios may help better illustrate how life insurance can be used as collateral. Here are two examples to consider:

• Steve wants to take out a 15-year mortgage for $500,000. He currently does not have any life insurance. He agrees to buy a 15-year term policy with a death benefit of $500,000 to use as a collateral assignment until he pays off the mortgage. He lists his daughter as the primary beneficiary. Ten years later, he passes away with $150,000 left on his mortgage. The term life insurance will first pay $150,000 to the lender to cover the outstanding debt. The remaining $350,000 will then go to his daughter.

• Kristi wants to take out a $100,000 personal loan to help start a business. She already owns a $300,000 whole life policy with $25,000 in cash value. She puts this policy up as collateral. Unfortunately, Kristi's business does not succeed, and she is unable to pay back any of the loan. The lender takes over the policy through the collateral assignment. They first take the $25,000 of cash value for repayment. Once Kristi passes away, the lender would use the death benefit to cover the remaining debt. Anything left would go to whoever Kristi listed as the beneficiary.

How Do You Set Up a Collateral Assignment?

While the exact process for setting up this arrangement will depend on your lender and insurer, there are a few common steps. Here are five actions you could take:

1. Review Your Lender's Requirements

You can ask your lender whether they allow a collateral assignment of life insurance. If so, check what they require for this arrangement. For example, do they allow all types of life insurance policies or only certain ones, like whole life? If you have an existing policy, would they accept it for the assignment? Or would you need to buy a new policy for this arrangement?

2. Set Up Your Life Insurance Coverage

If you already have life insurance and your insurer is willing to accept it, you could use it for the collateral assignment. If you don't have life insurance or your death benefit isn't large enough, you would need to purchase another policy. Be sure to ask your lender whether they only work with certain life insurance companies.

3. Fill Out the Collateral Assignment Forms

Contact your life insurance company for a collateral assignment form. This form lists information about your loan, such as the amount, the repayment schedule and the lender. Once you and your lender sign this form, your insurer can officially add the lender as the collateral assignee for your policy.

4. Finish Setting Up Your Loan

With your collateral assignment in place, you and the lender would then complete the loan application process. Once you get approved, they would send you the loan funds, secured using your life insurance.

5. Pay Off the Loan to End the Collateral Assignment

You would pay off your debt according to the lenders' payment schedule. Once you've made the final payment, you would contact your life insurance company to let them know. They would confirm with your lender and then end the collateral assignment. From that point on, the death benefit would go to your primary beneficiary, not to the lender.

What Are the Benefits of an Assignment?

• It can help your chances of qualifying for a loan. You aren't guaranteed to qualify for a loan. Having life insurance as collateral could make the difference for your approval. Collateral can make up for other issues, such as having a low credit score or small down payment.
• It can reduce your loan interest rate. When you put up collateral, you reduce the financial risk for the lender. This ensures they have another way to get their money back if you miss the loan payments. In exchange, they may offer you a lower interest rate. The numbers could potentially work out where the amount you save in interest is enough to cover your life insurance premiums or more.
• It can help protect your other assets. You could put up other assets for collateral, such as your home or car. But if you miss payments, the lender could take this property from you. While the same is true for life insurance, you might prefer this approach versus risking your home or your vehicle.

What Are the Possible Drawbacks?

• It reduces your life insurance benefits. When you have a collateral assignment of life insurance, the lender gets the first priority of collecting it. If your policy has cash value, the agreement might restrict your ability to take it out until you've paid off the debt. If you die without paying off your debt, the death benefit will first go to paying it off. Only if there's any benefit remaining will it go to your beneficiaries.
• It creates an extra insurance cost. To meet your collateral assignment agreement, you must have life insurance. The life insurance company will charge premiums. This is another cost on top of your loan payments.
• There is no guarantee of qualifying for life insurance. If you don't already have life insurance, you can try buying a policy for this arrangement. However, you are not guaranteed to qualify. You would need to undergo health underwriting and meet the provider's requirements. If you have health issues, it could drive up the insurance cost and make a collateral assignment not worth it. You could even be denied life insurance.

What Common Mistakes Should be Avoided When Assigning Collateral?

• Not checking with the lender's requirements first. Your lender might only accept certain types of life insurance policies or ones from specific companies. If you don't check before signing up, you might purchase a policy that the lender won't accept. Then you'd need to start the insurance application process over again before you can take out your loan.
• Naming the lender as the beneficiary. If you name the lender as your primary beneficiary, the lender is legally entitled to the full amount of your life insurance death benefit when you die. This is true even if the death benefit is larger than your unpaid loan balance. Make sure to go through the proper collateral assignment process so your life insurance only pays off your debt and nothing more. That way, any remaining benefit goes to whoever you've chosen as your beneficiary.
• Canceling your life insurance before paying off the debt. Your collateral assignment agreement requires you to keep your life insurance in place during the entire life of the loan. If you cancel the policy before then, the lender could increase your interest rate. They could also demand repayment of the entire loan at that moment since you breached the contract.
• Not having enough coverage for beneficiaries. A collateral assignment reduces the life insurance death benefit for your other beneficiaries, such as your spouse and children. Before using this agreement, make sure you have enough in either life insurance coverage or other assets to cover your final expenses and provide for family members depending on your income.

What Alternatives Could You Use for Your Loan?

• Use life insurance cash value. If your life insurance has cash value, would it be enough to cover your current financial needs? If so, you could withdraw the life insurance cash value. You could also borrow the money through a loan and then pay it back into your policy to use again in the future. However, both approaches will reduce the size of the death benefit for your beneficiary. You would also owe interest on a loan. If your withdrawal is more than what you paid in premiums, you'd owe income tax for taking out the gains. Compare these costs versus owing interest to a lender.
• Take out an unsecured loan. You could also see how much it would cost to borrow without putting up collateral. Just keep in mind the loan interest rate would be higher. You can then compare how much extra you would owe in interest versus the cost of paying life insurance. In some cases, it may be less expensive to borrow through an unsecured loan, especially if you don't need life insurance for other reasons.
• Use other assets. If you own a house, car or an investment account, you could put those up for collateral instead of life insurance. If you've paid off some of your mortgage, you could also borrow using a home equity line of credit. The drawback is that if you miss loan payments, you risk losing your home, car or any other asset you put up for collateral.
• Find a co-signer. If you are having trouble qualifying for a loan on your own, a co-signer could potentially help. This other person agrees to pay off the loan if you miss payments. This makes it safer for the lender. However, if you miss payments, you could hurt the credit score of the other person. They legally need to pay off the debt too.

Should You Consider a Collateral Assignment of Life Insurance?

A collateral assignment of life insurance can make sense if you already have life insurance or you are healthy enough to qualify for a new policy. It also could be worth using if you have addressed your life insurance needs already. Lastly, this arrangement can make sense if you don't want to risk your other assets or if you don't have any other assets for collateral.

If you don't have life insurance and don't think you could qualify for a new, affordable policy because of health issues, this approach might not be an option. If you have life insurance but don't want to risk not having enough coverage for your beneficiaries, this approach also might not be worth it.

To decide if this approach may be right for you, consider speaking with a financial professional. They can compare your other borrowing options and offer guidance based on your specific needs. If a collateral assignment is the best move, they can also help you with your insurance application.