When it comes to lending a borrower money, banks tend to play it safe. If, for example, you request a mortgage pre-approval letter, apply for a business loan, or prepare to take on a significant amount of debt, the bank or lender is going to want to ensure that you have the financial resources to pay off your debt without going into default. In some cases, your lender may request that you offer your life insurance policy as a form of collateral — that is, that you use the value of your life insurance policy as a way of guaranteeing the money you owe on your loan.

Creating a collateral assignment of life insurance might help you get approved for a loan or mortgage — but is it necessarily the wisest move? By giving a bank or lender a collateral assignment on your life insurance policy, you are giving them the right to claim any money you still owe them before your life insurance payout is distributed to your primary beneficiary (or beneficiaries).

This means that your loved ones could receive fewer life insurance benefits, depending on whether you are able to pay off your debts and release the collateral assignment before you die.

We asked two Haven Life experts — Paya Schlass, Customer Success Manager, and Luis Martinez, Regulatory Compliance Analyst — to explain what this security agreement is for life insurance, why a lender might request that you include your life insurance policy as collateral, and what you can do to ensure that the collateral assignment doesn’t make it more difficult for your loved ones to receive their life insurance benefits.

What is collateral assignment of life insurance?

A collateral assignment of life insurance allows  a borrower to use their life insurance policy as collateral on an existing debt.

“In some cases, when you apply for a loan, the lender may require that you buy a new life insurance policy or use an existing life insurance policy as collateral,” says Schlass. “With this security arrangement, if the insured dies, your policy will be paid out to your lender first before paying out to your primary beneficiary or beneficiaries.”

Adding a collateral assignment to your life insurance policy does not prevent you from designating life insurance beneficiaries such as partners and children, nor does it prevent your loved ones from receiving a financial benefit after you die. The collateral assignment simply specifies the order in which your life insurance payout is distributed.

“The assignment gets first priority of the death benefit,” explains Martinez. “The beneficiaries get whatever’s left.”

How much of the death benefit is a collateral assignee allowed to take? A collateral assignment for your life insurance coverage only allows the bank or lender to claim the amount of money still owed on a outstanding loan or debt.

If you have a $500,000 life insurance policy and die while still owing $50,000 on a business loan, the lender could claim $50,000 of your death benefit — assuming, of course, that you listed that lender as a collateral assignee.

If a lender is not a collateral assignee on your existing life insurance policy, they may still try to claim outstanding debts out of your estate; they just won’t have first dibs on your life insurance death benefit.

“Talk to your financial adviser before setting up a collateral assignment,” Martinez advises. This type of arrangement can have a significant impact on the way life insurance benefits are distributed for a policy owner, so make sure you have explored all of your options and are willing to list your life insurance policy as collateral before signing any life insurance collateral assignment forms.

What are some common life insurance collateral assignments?

If you owe money to an institution — or a person — you can list them as a collateral assignee on your life insurance policy. “Creditors can be whoever you owe money to,” Martinez explains. “Banks, credit card companies, individuals.”

That said, some types of collateral assignments are much more common than others. “Collateral assignment of life insurance is typically associated with business loans and mortgages,” says Martinez. If you’re launching a small business and applying for a loan to help you get started, the bank might request that you include your life insurance policy as collateral.

This ensures that the bank will be able to collect the money you owe them even if you die before you are able to pay off your debt. Similarly, people who need a little extra boost when they begin the homebuying process might be able to offer their life insurance policy as collateral on their mortgage.

There are certain types of debts that rarely make it into collateral assignments of life insurance coverage. “It doesn’t really apply to student loans or credit card debt,” notes Martinez. (This doesn’t mean that these kinds of debts disappear when you die, however — in fact, many people don’t realize that most debts remain active after death, and creditors will be well-prepared to claim what they are owed.)

Why do people create collateral assignments of life insurance?

Since banks and loan companies are going to do their best to collect their money regardless of whether you make them a collateral assignee on your life insurance policy, why do people create collateral assignments?

The answer is simple. “Some lenders require you to set up a collateral assignment of life insurance as a condition for a loan,” explains Martinez. “Not always, but this does happen.”

When a lender requests a collateral assignment agreement, it means that the lender suspects that you might not have enough assets in your estate to cover the costs of your outstanding loan or mortgage — and the lender wants the additional security agreement that comes with knowing they’ll be able to collect on your life insurance policy if you fail to pay off your debts.

Collateral assignments of life insurance become even more important if you have the kind of whole life insurance policy that has an associated cash value — that is, money that can be withdrawn from the policy at any time. “If you default on your debts, the assignee could come after your life insurance policy’s cash value,” says Martinez. “Haven Life policies have no cash value, so that isn’t an issue with us.”

How do you create a collateral assignment on your life insurance policy?

In most cases, you won’t be able to create a collateral assignment when you apply for life insurance online. Instead, you’ll complete an Assignment of Life Insurance Policy as Collateral form after you receive your new life insurance policy.

“At Haven Life, we only allow collateral assignment once a policy is issued,” Schlass explains. “If individuals are looking to collaterally assign their policy, they cannot do this at time of application. However, if they own a policy and decide to make the change during the life of the policy, we can support this.”

As Schlass notes, you can fill out an Assignment of Life Insurance Policy as Collateral form at any time during the life of your policy. Some people may fill out this form immediately after being approved for life insurance, especially if taking out a life insurance policy and creating a collateral assignment is one of the steps they need to complete to be approved for a mortgage or loan.

Other people may have had life insurance coverage in place for years before finding themselves in a situation in which they need to create a collateral assignment of life insurance.

There’s one important detail associated with the Assignment of Life Insurance Policy as Collateral form that you should be aware of — and it’s the fact that the form does not include the amount of money you owe your assignee.

“When you add a collateral assignment to your life insurance policy, you’re signing the form but you’re not telling us how much the lien is for,” says Martinez. 

In other words, you’re trusting your creditor to keep track of the amount of money you owe them. As you continue to pay off your debts, the amount you owe your creditor will decrease — and the amount of money they can claim on your life insurance policy will get smaller and smaller.

What happens if you need to change your collateral assignment?

Let’s say you pay off your debt for an outstanding loan in full — what happens to your collateral assignment of life insurance? The best thing you can do after paying off a mortgage, business loan or other collaterally assigned debt is contact your life insurance company. Let them know that your debts from your outstanding loan are repaid and your life insurance policy should no longer be used as collateral.

“If you pay off your debts, contact your life insurance provider so they can release the assignee,” explains Martinez.

What happens if you don’t contact your life insurance company to change your collateral assignment of life insurance? Since you no longer owe any money to your assignee, they won’t be able to claim any portion of your life insurance policy’s death benefit — but since collateral assignments have to be settled before any money is distributed to your beneficiaries, contacting the assignee and confirming the debts have been repaid can slow down the process.

In most cases, it takes fewer than 24 hours for your beneficiaries to receive their life insurance payout; if there is still a collateral assignee on your life insurance policy, it could take much longer.

Since your beneficiaries may be depending on your life insurance policy to cover your final expenses, pay off medical bills or keep up with the costs of running a household, it’s important to ensure that they are provided for as quickly as possible — and, financially speaking, as much as possible.

“What’s your plan?” asks Martinez. “You’re purchasing a life insurance policy to ensure your loved ones are protected.” While a collateral assignment of life insurance can benefit your loved ones by allowing you to purchase a home, start a business or take out a loan when you really need it, paying off your debts and releasing the assignee will do even more to protect your loved ones long-term. As Martinez explains, “You’re banking on your policy to benefit your loved ones.”

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