Life insurance as business loan collateral

This article will ... Review the common reasons why businesses get turned down for loans. Detail how life insurance can be used as collateral for business loans. Note the situations where life insurance is likely to be required for a loan.

Businesses go through several stages. When they reach the growth stage, they may require additional financing above and beyond what the owner has saved or what friends and family can offer. These improvements may include increasing inventory, retooling existing or purchasing new equipment, expanding the building, or developing a new market.

In fact, a recent Forbes Advisor survey sought to identify how business owners used funds from their business loans. The most common use of the funds was for business expansion, with 42 percent selecting this option. Equipment purchases came in second, cited by 29 percent of respondents, followed closely by marketing and advertising, business franchising, and commercial real estate purchases/remodeling.

The most common business loan program

A U.S. Small Business Administration (SBA) 7(a) loan is the flagship product of the SBA loan program and offers loans up to $5 million that business owners can use to cover everything from working capital and inventory costs to real estate purchases and construction of a new building. However, an analysis of five years of 7(a) loan data reveals a significant drop in average loan approval amounts.¹ In 2021, the nationwide average 7(a) loan amount was at a high of $704,581. But, in 2022, this average dropped to $538,903. For 2023, the average dropped again to $479,685.

Furthermore, 21 percent of all commercial loans were declined in 2022. The most common reasons for loan denial, according to the SBA, include:

Poor personal or business credit scores
Insufficient collateral
Insufficient cash flow
High existing debt

Lenders often find themselves reviewing many worthwhile loan applications; however, many are declined due to a lack of adequate collateral. Life insurance used as collateral is an option to help you get your business loan approved.

Life insurance as business loan collateral

Here’s how it works: You (or your business) own the life insurance policy, choose your beneficiary, and make the policy premium payments. If you already own a life insurance policy (and your insurer allows it), you can assign part of your existing policy as collateral coverage. Or you can purchase a new policy that includes your lender as an assignee on the policy.

While your loan is in effect, your lender retains “collateral assignment” of the policy. That means if the person insured by the policy dies while the loan is in effect, your lender has the right to claim a portion of the policy proceeds equal to the outstanding loan balance. Any remaining proceeds are paid to the beneficiary you’ve named.

The collateral assignment ends when you’ve paid off your loan. Your lender will no longer have any rights to the policy. Your policy remains in effect as long as you continue to make the premium payments (or, in the case of a term life policy, the term is completed) and can be used for other business planning needs, such as buy-sell agreement funding or key person protection.

When is life insurance required for a loan?

Your lender may require you to have life insurance before closing on your loan because it protects everyone involved if you (or a business partner) pass away. Every small-business loan is different, so there’s no standard answer for when life insurance will be required. However, here are some general guidelines regarding life insurance requirements for business loans:

An SBA 7(a) loan typically requires life insurance for the full loan amount. However, in certain cases, the life insurance requirement may be reduced or waived if you’ve pledged significant personal or business assets as collateral.
For an SBA 504 loan, life insurance is typically only required if your collateral doesn’t fully cover the loan. In some SBA 504 loan arrangements, the property or equipment you’re purchasing with the loan is sufficient collateral.
For a non-SBA commercial loan through a bank, life insurance is required solely at the discretion of the lending institution.

Conclusion

Life insurance for SBA and other business loans not only protects your lender’s interest, but also protects your family from having to take on your outstanding business loan debt in the event something unforeseen or unfortunate occurs. While this is a circumstance that no one wants to imagine, it’s a reality in small-business lending situations. The last thing you want as a business owner is to have your business partner or your heirs be liable for the debt and forced to liquidate assets in order to meet the obligations of the lender. And life insurance as collateral can help protect against this risk.