Can I Borrow Against My Life Insurance Policy?

A life insurance policy loan offers a way to access funds from certain types of life insurance policies while the policyholder is still living. This financial tool allows individuals to borrow money directly from their insurance company, using the accumulated cash value within their policy as collateral. Unlike traditional loans from banks, these policy loans do not involve a complex application process or credit checks. This ability to tap into accumulated value provides a flexible financial resource without surrendering the policy entirely.

What Policies Allow Borrowing

Life insurance policies vary, with only specific types accumulating cash value, which is required for a policy loan. Cash value is a savings component that grows over time within permanent life insurance policies. A portion of each premium contributes to this cash value, accumulating interest or investment gains on a tax-deferred basis.

Policies that build cash value are permanent life insurance, designed to provide coverage for an individual’s entire lifetime. These include whole life, universal life, and variable universal life insurance. Whole life offers a guaranteed death benefit and cash value growth at a fixed rate. Universal life provides flexibility in premium payments and death benefit adjustments, with cash value growth tied to an insurer-set interest rate. Variable universal life allows policyholders to invest cash value in sub-accounts, offering potential for higher returns but also greater risk. Term life insurance is for a specific period and does not build cash value, so it cannot be borrowed against.

How Policy Loans Work

A policy loan differs from a conventional bank loan. Policyholders do not withdraw money from their cash value. Instead, the insurer lends money, using the accumulated cash value as collateral. The cash value remains in the policy and can continue to earn interest or dividends, depending on the policy type, even while a loan is outstanding.

The process of obtaining a policy loan is straightforward and does not involve a credit check or lengthy approval. Since the loan is secured by the policy’s cash value, the insurer faces minimal risk. The amount a policyholder can borrow is typically limited to a percentage of the available cash value, often up to 90%. For instance, if a policy has $10,000 in cash value, a policyholder might be able to borrow up to $9,000.

Interest accrues on the outstanding loan balance. Interest rates for policy loans are generally competitive, often ranging from 5% to 8%, which can be lower than rates for personal loans or credit cards. This interest is paid back to the insurance company; if unpaid, it increases the loan balance, though cash value theoretically continues to grow. Policyholders have flexibility in how they pay the interest, including allowing it to be added to the loan balance. The policy remains in force as long as premiums are paid and the loan balance, including accrued interest, does not exceed the policy’s cash value.

Impacts of Taking a Policy Loan

Taking a loan against a life insurance policy can have several implications for the policy and its beneficiaries, particularly if the loan is not repaid. An outstanding policy loan directly reduces the death benefit. If the policyholder passes away with an unpaid loan balance, including any accrued interest, that amount is subtracted from the death benefit. This means the beneficiaries will receive a lower payout than the policy’s stated face value.

The policy risks lapsing if the outstanding loan balance, combined with accrued interest, grows to exceed the cash value. If this occurs, the insurance company may terminate the policy, resulting in a loss of coverage. This eliminates life insurance protection and can trigger significant tax consequences.

Policy loans are generally considered tax-free when taken, as the Internal Revenue Service (IRS) views them as advances against the policy’s cash value rather than taxable income. However, this tax-free status is contingent upon the policy remaining in force. If the policy lapses or is surrendered with an outstanding loan, the amount borrowed, up to the gain in the policy, can become taxable income. Gain is typically defined as the cash value exceeding total premiums paid into the policy, also known as the cost basis. If a policy lapses under these circumstances, the policyholder could face an unexpected tax bill on the amount that previously accumulated tax-deferred.

Repaying a Policy Loan

A distinguishing feature of a life insurance policy loan is its flexibility regarding repayment. Unlike traditional bank loans with rigid monthly payment schedules, policyholders are not required to adhere to a strict repayment plan. They can repay the loan in installments, a lump-sum payment, or choose not to repay it at all during their lifetime. While there is no mandatory repayment schedule, interest continues to accrue on the outstanding balance.

Repaying the loan offers several advantages, primarily restoring the policy’s full death benefit. By paying back the principal and accrued interest, the amount that would otherwise be deducted from the death benefit is reinstated, ensuring beneficiaries receive the full intended payout. Additionally, repayment allows the policy’s cash value to continue growing unimpeded. Since the cash value serves as collateral and continues to earn interest, repaying the loan ensures the full cash value is available for future use or can contribute to the policy’s long-term growth.

Although repayment is flexible, it is important to monitor the loan balance, especially the accrued interest. If interest payments are not made, the interest can be added to the principal, causing the loan balance to grow. Allowing the loan balance to approach or exceed the cash value can jeopardize the policy’s in-force status, potentially leading to a lapse. Therefore, while there is no pressure for immediate repayment, actively managing and ideally repaying the loan is crucial for maintaining the policy’s value and ensuring its intended benefits for the future.