When you go to take out a loan, the lender may ask you to put up collateral — a valuable asset that backs up your promise to repay the debt.

Life insurance is one way to meet this requirement, since you can use your policy as collateral. Here's how the process works and when it might make sense for you.

What Is a Collateral Assignment of Life Insurance?

A collateral assignment describes when your life insurance policy acts as your loan collateral. The lender has two potential ways to collect.

First, if you die before repaying their loan, the life insurance death benefit would pay off your debt. Second, some life insurance policies build cash value. This is money that you could take out while you're still alive. The lender could also use this as collateral and take the cash value if you fail to make the loan payments.

Do All Life Insurance Policies Work for These Agreements?

Not all policies qualify for assignment. To use life insurance as collateral, you must own the policy. This means you have the right to change the beneficiary (the person or company that will receive the death benefit).

This doesn't necessarily mean the insurance policy is based on your life. It's possible to own insurance on the life of another person, like your spouse, and put this policy up as collateral. Alternatively, if there's a policy on your life but someone else owns it, you couldn't use it as collateral.

Lenders also typically prefer a permanent life insurance policy rather than term. Term life is temporary and expires after a set period, such as five or 10 years. With term, a lender might be concerned that you won't pay off the debt by the end of the term. At that point, your insurance coverage ends and the lender loses their collateral.

Permanent insurance does not expire so long as you keep paying the premiums. It can also build cash value, whereas term does not. For these reasons, lenders generally prefer using permanent policies for these agreements. However, you may find some willing to accept term life insurance as well.

How Do You Set Up a Collateral Assignment of Life Insurance?

1. Find a Lender

Not all lenders will accept these agreements. It helps to find a lender first, because then you can see what type of life insurance policies they would accept.

2. Set Up Your Life Insurance

You need to have a life insurance policy. You can use one you already own, or you can apply with a life insurance company to set up a new policy. Before applying, make sure they accept collateral assignments. Once you have the insurance contract in place, you can move forward with the assignment.

3. Contact Your Life Insurance

Once your life insurance has sent you the appropriate paperwork, both you and your lender will need to fill out the documents and list the terms and conditions of repaying your loan. After reviewing your paperwork, the insurance company will send a contract to both you and the lender, making the agreement official.

4. Pay Off Your Loan

The lender will be the beneficiary of your life insurance as long as you are in debt. Once you pay off the debt, the lender will send a release to your insurance company to end the assignment. From then on, the full death benefit would go to your named beneficiaries instead.

What Are the Benefits of a Collateral Assignment?

It Protects Your Other Property

Instead of life insurance, you could put up other pieces of property for collateral, such as your home or car. However, if you miss payments on your loan, the lender can seize these assets, even if you depend on them for your day-to-day life. With insurance as collateral, you avoid risking these other assets.

It Helps You Qualify for Loan

Lenders may worry that they won't get their money back if you die before paying off the loan. With a collateral assignment, a lender might be more open to accepting an application, because they know the insurance would pay off the loan in this situation.

It Prevents the Need for a Co-signer

A lender may ask you to find a co-signer for a loan. This person would be legally responsible for paying off the debt if you don't. With life insurance, the lender might skip this requirement.

It Reduces Your Loan Interest Rate

Lenders typically charge a lower interest rate for loans secured with collateral. By assigning your life insurance, you'll save on the loan costs. This could make up some or even all the cost of paying for the life insurance.

What Are the Drawbacks of a Collateral Assignment?

You Must Qualify for Life Insurance

If you don't already own life insurance, you'll need to set up a new policy. This isn't guaranteed. Most insurers ask you to pass health underwriting and take a medical exam. If you have health issues, the policy could be more expensive, making this strategy less cost effective. You also might not qualify.

You Must Keep Up With Insurance Payments

Life insurance policies charge a premium every month. Your loan contract will require you to keep up with the insurance payments. If you don't, the lender may pay the premiums themselves and add the cost to your outstanding debt.

You May Lose Control of the Cash Value

If your policy has cash value, the lender could set restrictions on your ability to access this money until you've paid off the debt.

You Could Leave a Smaller Inheritance

If you die before paying off your loan, your insurance policy will first pay off the outstanding debt. Your heirs will only receive money if there's anything left. This could create trouble if they were counting on getting this lump sum payout.

Are There Alternatives Worth Considering?

Apart from setting up a collateral assignment of life insurance, there are some alternative approaches you could use for your loan:

Spend or Borrow Your Cash Value

If your existing life insurance policy has cash value, could that be enough to cover your financial needs? You could withdraw your cash value whenever you want. However, you would owe income tax for taking out any earnings above what you paid in premiums.

You could also take out a policy loan without owing taxes. After borrowing, it's up to you whether you pay the loan back into the policy so you'd have cash value again. You can also wait and have the death benefit pay off the cash value loan.

Use Other Property for Collateral

Besides life insurance, you could put up your house as collateral using a home equity loan. You may also be able to put up a car, your investment brokerage account, or another valuable asset as collateral. The collateral is at risk if you don't pay the loan, but for some this option may be better than forfeiting life insurance.

Take Out an Unsecured Loan

You should ask the lender how much you would owe for an unsecured loan that doesn't require collateral. Compare that monthly payment against the cost of a secured loan, especially if you also need to pay extra for life insurance. The numbers may work out in favor of an unsecured loan. Even if this path ends up costing more, some people might still prefer paying more over risking collateral.

As you weigh your approach, consider speaking with an insurance agent. They can further explain the process of a collateral assignment and set up whatever arrangement you decide is your best option.