Can I Borrow From My Whole Life Insurance?

Whole life insurance is a permanent life insurance option, offering lifelong coverage and building cash value over time. This cash value component represents a portion of the premium payments that accumulates within the policy, growing on a tax-deferred basis. Unlike term life insurance, whole life policies are designed to endure for the policyholder’s entire life. As the policy matures, this accumulated cash value can become a financial resource, accessible by the policyholder for various needs.

Basics of Whole Life Policy Loans

A loan against a whole life insurance policy is not a traditional loan from a bank or financial institution. Instead, it is an advance provided by the insurance company, secured by the policy’s own accumulated cash value. The cash value serves as collateral for the loan, meaning policyholders typically do not undergo a credit check or a lengthy application process when requesting a loan.

The policy itself continues to remain in force, and its cash value may continue to earn interest or dividends, depending on the policy’s terms. However, interest accrues on the outstanding loan balance, and this interest rate, often between 5% and 8%, is typically set by the insurance company. Repayment of the loan is notably flexible, without a strict schedule or penalties for non-payment, unlike conventional loans. Nevertheless, if the loan and its accrued interest are not repaid, they will reduce the policy’s death benefit.

Over time, if the outstanding loan balance, including accrued interest, grows to exceed the policy’s cash value, the policy faces the risk of lapsing. This unique loan mechanism allows policyholders to access funds without liquidating their policy, maintaining the life insurance coverage as long as the policy remains solvent. It generally takes several years for a whole life policy to build sufficient cash value to be eligible for a loan.

Financial Impact of a Policy Loan

Taking a loan against a whole life policy directly affects the financial components of the insurance coverage. An outstanding loan balance, along with any accrued interest, will reduce the policy’s death benefit. Upon the policyholder’s passing, the beneficiaries will receive the stated death benefit minus the unpaid loan amount and any accumulated interest. For example, a $250,000 death benefit with a $50,000 outstanding loan would result in a $200,000 payout to beneficiaries.

The portion of the cash value used as collateral for the loan may no longer earn interest or dividends at the same rate, or at all, depending on the policy’s terms. This can slow the overall growth of the policy’s cash value over time, as the loaned amount is not actively participating in the policy’s investment component.

A significant risk associated with policy loans is the potential for policy lapse. If the total outstanding loan balance, including interest, grows to exceed the policy’s cash value, the insurance company may terminate the policy. A policy lapse while a loan is outstanding can trigger unexpected tax consequences, as the unpaid loan amount may be treated as a taxable distribution.

Tax Implications of Policy Loans

Generally, loans taken against a whole life insurance policy are not considered taxable income. This is because the loan is viewed as an advance of the policyholder’s own money, secured by the cash value, rather than a distribution or income. As long as the policy remains in force, the loan proceeds are typically received tax-free.

However, specific circumstances can cause a policy loan to become taxable. If the policy lapses or is surrendered while an outstanding loan balance exists, the loan amount can be treated as taxable income to the extent it exceeds the policy’s cost basis. The cost basis generally refers to the total premiums paid into the policy, minus any previous tax-free withdrawals.

Additionally, if a policy is classified as a Modified Endowment Contract (MEC) due to overfunding beyond IRS limits, the tax rules for loans change. Loans from an MEC are treated on a “last-in, first-out” (LIFO) basis for tax purposes, meaning any gains in the policy are considered withdrawn first and are subject to ordinary income tax. If the policyholder is under age 59½, an additional 10% federal penalty tax may also apply to these taxable gains from an MEC loan.

Accessing and Handling Your Policy Loan

Obtaining a loan from a whole life insurance policy typically involves a straightforward process. Policyholders usually begin by contacting their insurance company or agent to request a loan. The insurer will then provide the necessary forms to complete. Since the loan is secured by the policy’s cash value, there is no credit check or extensive approval process, and funds can often be disbursed within days or weeks. Most insurers allow borrowing up to 90% of the policy’s accumulated cash value.

Repayment of a whole life policy loan offers considerable flexibility. There is generally no mandatory repayment schedule, and policyholders can choose to repay the principal and interest in full, make partial payments, or simply let the loan balance accrue. Some policyholders opt to pay only the interest annually to prevent the loan balance from growing, while others may allow the loan and interest to be deducted from the death benefit upon their passing.

If the loan is not repaid, the outstanding balance and accrued interest will reduce the death benefit paid to beneficiaries. While there is no strict requirement to repay the loan, allowing the balance to grow unchecked can lead to significant reductions in the policy’s payout. The most severe consequence of non-repayment is the risk of the policy lapsing if the loan balance, including interest, eventually exceeds the cash value. This results in the loss of coverage and potential tax implications on the untaxed gain of the policy.