Final answer:
Borrowing against the cash value of a life insurance policy involves taking out a loan that needs to be repaid with interest. Failure to repay the loan results in a reduced death benefit for beneficiaries.
Step-by-step explanation:
When a policy owner borrows against the cash value of their life insurance policy, they are taking out a loan from their own policy's accumulated funds. The cash value acts as a savings account within a cash-value (whole) life insurance policy, which grows over time and can be used by the policyholder.
This loan must be repaid with interest, and if it is not repaid before the policyholder's death, the insurance company will deduct the outstanding loan amount plus interest from the death benefit payout to beneficiaries. Since the cash value is part of the policy's death benefit, borrowing against it reduces the ultimate payout to the policy's beneficiaries upon the policyholder's death.
Lenders, such as life insurance companies, can be put at risk due to an asset-liability mismatch, similar to banks that can face problems when interest rates rise substantially after they have loaned out money at lower interest rates. If they are unable to adjust the rates paid to depositors, or if doing so would cause them to pay more in interest to depositors than they receive from borrowers, the financial stability of the institution can be compromised. Hence, it's vital for the policy owner to consider the possible implications of taking a loan against their life insurance policy's cash value.