Can I Borrow Money From My Life Insurance Policy?

A life insurance policy loan offers an option for accessing funds, allowing policyholders to borrow money against the accumulated value within their permanent life insurance policy. This mechanism provides a way to tap into a policy’s living benefits during the insured’s lifetime. Instead of withdrawing funds directly, which can have different implications, this approach involves taking a loan from the insurer, with the policy’s cash value serving as collateral. This feature makes certain life insurance policies flexible financial tools.

Types of Policies That Allow Loans

The ability to obtain a loan from a life insurance policy is exclusively tied to policies that build cash value. These are permanent life insurance policies, which include types such as whole life, universal life, and variable universal life insurance. Each premium payment made to these policies contributes a portion to a savings component, which accumulates cash value over time. This cash value grows on a tax-deferred basis, similar to how interest accrues in a savings account.

The cash value represents a portion of the policy that can be accessed by the policyholder during their lifetime. For instance, in a whole life policy, the cash value is guaranteed to grow at a specified rate. Universal life policies offer more flexibility, allowing adjustments to premiums and death benefits, which can influence cash value accumulation. In contrast, term life insurance policies do not build cash value because they are designed to provide coverage for a specific period. Consequently, term life policyholders cannot obtain loans against their policies.

Understanding How Policy Loans Operate

A life insurance policy loan functions differently from a traditional bank loan because the money is borrowed from the insurance company, using the policy’s cash value as collateral. The loan is not a withdrawal from the cash value itself; rather, it is an advance from the insurer, secured by the cash value. This means the policy remains in force, and the cash value continues to grow, potentially earning interest or dividends, even while the loan is outstanding.

Interest is charged on the outstanding loan balance, and this rate is set by the insurer and can be lower than rates for personal loans or credit cards. This interest accrues whether or not regular payments are made. Policy loans do not come with a fixed repayment schedule, offering policyholders flexibility in how and when they repay the borrowed funds. Any outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries if the insured passes away before the loan is fully repaid.

In some policies, the interest rate on the loan may be fixed, while in others, it can be variable, adjusting based on market conditions. How the loan affects the policy’s internal growth, particularly dividends in participating policies, depends on whether the insurer uses a “direct recognition” or “non-direct recognition” method. Direct recognition means the dividend rate on the borrowed portion of the cash value may be adjusted, while non-direct recognition allows the entire cash value to continue earning the same dividend rate, regardless of an outstanding loan. Policy loans are generally tax-free, provided the policy remains active and does not lapse.

Important Considerations for Policyholders

Before taking a life insurance policy loan, policyholders must understand the potential impacts on their financial planning and policy’s integrity. The most direct consequence is the reduction of the death benefit. Any outstanding loan balance, along with accrued interest, will be subtracted from the death benefit paid to beneficiaries upon the insured’s death. For example, a $250,000 policy with a $50,000 outstanding loan would result in a $200,000 payout to beneficiaries.

A significant risk associated with policy loans is the potential for the policy to lapse. If the outstanding loan balance, including accrued interest, grows to exceed the policy’s cash value, the policy can terminate. A policy lapse due to an outstanding loan can trigger immediate tax consequences, as the loan amount that was previously tax-free may become taxable income. Specifically, the amount of gain (cash value minus premiums paid) within the policy can become taxable as ordinary income, even if no cash was received at the time of lapse.

Continuous interest accrual on an unpaid loan can erode the policy’s cash value over time, potentially leading to this lapse scenario if not managed carefully. To mitigate this, some policyholders pay the accruing interest. If a policy is classified as a Modified Endowment Contract (MEC) due to excessive premiums paid, loans taken from it are taxed differently, with earnings taxed first and potentially subject to a 10% penalty if the policyholder is under age 59½. Policyholders should review their specific policy’s terms and conditions and consider consulting with their insurer or a financial advisor.

Steps to Obtain a Policy Loan

Obtaining a policy loan is a straightforward process, distinct from securing a traditional loan. The first step is to contact your life insurance company or a licensed agent. This initial contact allows you to inquire about your specific policy’s loan provisions, confirm the available cash value, and understand the current interest rates applicable to policy loans.

The insurer will then provide a loan application form. This form requires basic policyholder information, such as name, address, and policy number, along with the desired loan amount. Policyholders usually need to specify how they wish to receive the funds, often via direct deposit. The amount available for a loan cannot exceed a certain percentage of the policy’s current cash value. Once the completed form is submitted, processing time is short, with funds often disbursed within a few business days.