Can I Borrow Against Term Life Insurance?

Life insurance functions as a financial planning tool, offering a measure of security for beneficiaries. It serves as a contract where, in exchange for regular payments, an insurer provides a lump sum payment upon the insured individual’s passing. Various types of policies exist, each with distinct features that determine how they can provide liquidity or serve as a financial asset during one’s lifetime. Understanding these differences is important when considering how life insurance can align with broader financial objectives.

Understanding Term Life Insurance

Term life insurance provides financial protection for a specific period. This period can range from a few years to several decades, commonly 10, 20, or 30 years. The primary purpose of this type of policy is to pay a predetermined death benefit to beneficiaries if the insured person dies within the specified term.

Premiums for term life insurance are typically fixed for the duration of the chosen term. Unlike some other forms of life insurance, term policies do not accumulate cash value or a savings component. If the policyholder outlives the term, the coverage simply expires, and no payout is made unless a return of premium rider was added at a higher cost.

The Absence of Cash Value

Term life insurance cannot be used to borrow funds due to its lack of cash value. A loan typically requires collateral or an accumulated asset against which to borrow. The premiums paid cover the cost of the death benefit and administrative expenses, rather than contributing to a growing cash reserve. Consequently, there is no pool of money within the policy from which to secure a loan.

Life Insurance Policies That Allow Loans

Permanent life insurance policies, such as whole life and universal life, build cash value that policyholders can leverage for loans. Cash value within these policies accumulates over time as a portion of each premium payment is allocated to a savings or investment component. Whole life insurance policies typically offer guaranteed cash value growth at a fixed interest rate. Universal life insurance policies, conversely, offer more flexibility with premiums and death benefits, and their cash value growth may be linked to market performance or current interest rates, often with a guaranteed minimum.

Policy loans from these permanent policies are not withdrawals of your own money, but rather a loan from the insurer using your policy’s cash value as collateral. The mechanics of a policy loan differ from traditional bank loans. Policy loans generally do not require a credit check or a formal approval process. While there is no strict repayment schedule, interest accrues on the loan, typically ranging from 5% to 8%. Unpaid loan balances, including accrued interest, will reduce the death benefit paid to beneficiaries upon the insured’s death.

Regarding taxation, policy loans are generally not considered taxable income as long as the policy remains in force and the loan amount does not exceed the total premiums paid into the policy. However, a policy can become a Modified Endowment Contract (MEC) if premium payments exceed certain IRS limits. If a policy is classified as an MEC, loans and withdrawals are taxed differently, and may incur an additional 10% penalty if the policyholder is under age 59½. If a policy with an outstanding loan lapses, any loan amount exceeding the cost basis (premiums paid) can become taxable income.

Exploring Other Financial Options

Since borrowing against term life insurance is not an option, individuals seeking liquidity have several alternative financial avenues. Personal loans from banks or credit unions offer a lump sum, often with fixed interest rates and repayment terms, though they typically require a credit check and may have higher interest rates than policy loans. Another option is a personal line of credit, which provides access to a revolving credit limit that can be drawn upon as needed.

Existing savings or investment accounts can also provide immediate funds. High-yield savings accounts or money market accounts offer liquidity. Certificates of deposit (CDs) can offer higher interest rates, though funds are typically locked in for a specific term, and early withdrawals may incur penalties. For homeowners, a home equity loan or a home equity line of credit (HELOC) allows borrowing against the equity built in their property, usually at lower interest rates than unsecured loans, but these options use the home as collateral.