What is cash value life insurance?

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• Permanent life insurance policies have a cash value component that you can use to build wealth.
• Term life insurance does not have cash value, which is why it's more affordable.
• There are various types of permanent life that invest the cash value differently.

There are two types of life insurance: permanent life and term life. Permanent life insurance has a death benefit for your beneficiaries and a cash value that you can use during your lifetime, and it never expires. Term life insurance also has a death benefit, but there's no cash value and your policy will expire after a specified amount of time.

The difference between term life insurance and permanent life insurance is similar to the difference between renting an apartment and owning a home. When you rent, you have a lease for a certain term. When that lease is over, you can renew — but most likely with a rent increase. Likewise, term insurance lasts for a specified period, and when it's up you can reapply for coverage, but the premiums most likely will go up as you age and your health deteriorates.

Term life insurance is the most affordable option because it doesn't have cash value and it expires. If you want a policy with a cash value that grows over time, you'll be looking at permanent life insurance.

What is cash value life insurance?

Cash value is a unique feature to permanent life insurance policies. Although the term "whole life insurance" is often used synonymously with permanent life insurance, whole life, universal life, and variable life are actually types of permanent life insurance. Other permanent life insurance policies are a variation of these three products. 

All permanent life insurance policies have a cash value that grows on a tax-deferred basis. You can take a loan on the cash value or use it as collateral during your lifetime, tax deferred. This is why permanent life insurance is considerably more expensive than term life insurance. The exact cost will vary based on the type of permanent life insurance policy you choose: whole, universal, variable, guaranteed universal, indexed universal, and variable universal.

The initial years of a permanent life insurance policy are expensive compared to what you'll pay in the future. "In the early years of overpayment, the cash value put inside the policy earns interest and you use that bucket of money to offset the cost of insurance when you're older," said Mark Williams, CEO of Brokers International.

The big difference between the types of permanent life insurance policies is how they manage the cash value —  in the insurance company's portfolio, stock market, or annuities.

How to use cash value life insurance during your lifetime

You can use the cash value of a permanent life insurance policy during your lifetime, for things such as paying your children's college tuition, funding a business, or purchasing a second home. Most people use the cash value to fund their retirement — paying themselves a monthly income when they stop working. Due to these features, permanent life insurance can function as an investment and wealth-building tool.

One reason that people get permanent life insurance is for the cash value and ability to get loans tax-free without using other assets as collateral. It can be used to pay for children's college tuition, fund a business, or purchase a second home. 

If you borrow money or take out a loan against your permanent life insurance policy's cash value, you don't pay tax on the loan, but you will pay interest. The interest you pay is based on current market rates and can be fixed or variable depending on the type of permanent life insurance policy you have.

What if you don't repay a loan on your permanent life insurance?

Williams said you can pay the loan back — or never pay it back, and keep the policy until you die. However, he noted if you die with an outstanding loan, the insurance company will reduce the death benefit payable to your beneficiaries by the outstanding loan amount. 

If you have enough cash value or dividends on your policy, you could be able to use the dividends to pay back the loan, depending on the type of permanent life insurance product you have.  

If you want to cancel your life insurance policy and you took out a loan that you haven't paid back, you'll need to contact your insurance company to start the process. The money you'll receive back when you cancel a permanent life insurance policy is called cash surrender value.

If you cancel your insurance policy while you still have a loan, you will receive the cash value minus the outstanding loan balance and any fees associated with canceling your policy. You will also have to pay taxes on the cash value received. Before surrendering your permanent life insurance policy, consult an accountant or tax professional about the tax implications.

Consult an expert before taking a loan on your cash value life insurance

Permanent life insurance is more than a payout for your beneficiaries. It's an opportunity to build wealth and fund your retirement through the cash value your policy accrues. If you're considering taking a loan against your permanent life insurance policy, consult an accountant and financial advisor first.

You want to understand any tax implications, the impact on your death benefits in case you don't pay back the loan, and how other assets are protected. This decision can't be made in a vacuum because everyone's needs vary. Involving an accountant and financial advisor can help you avoid making a decision that is not financially sound or advantageous for you.

Who needs cash value life insurance?

High-net-worth individuals — those with at least $1 million in liquid assets — often have permanent life insurance policies for tax benefits, endowments, and gifts. The cost is considerably higher than term life insurance because permanent life insurance is also a wealth-building tool. 

The average person may not be able to afford a $1 million permanent life insurance policy. Think of permanent life insurance coverage like equity in a home. You may not be able to get your dream home right off the bat, but you can get a starter home that also builds you wealth. With permanent life insurance, start with a smaller death benefit and increase it over time. And if you can't afford a permanent life insurance policy, get a term life policy that can be converted to a permanent policy. 

Williams also suggests a combination of permanent and term life insurance. For example, if you have $200,000 in permanent life and $300,000 in term for 20 years, at the end of 20 years the term life insurance policy goes away but you still have your $200,000 permanent policy that has earned cash value.

If you're considering permanent life insurance, it's wise to consult an accountant and financial advisor to determine which policy is best for you and the tax benefits and implications. It's worth taking the time to find the best policy for you, because once you've signed on the dotted line, it's a lot more difficult to make changes if you need to adjust your coverage.

Ronda Lee is an associate editor for insurance at Personal Finance Insider covering life, auto, homeowners, and renters insurance for consumers. She is also a licensed attorney who practiced litigation and insurance defense.