Can I Take a Loan Against My Life Insurance?

Life insurance can serve as a versatile financial tool, offering more than just a death benefit for beneficiaries. Policyholders may access accumulated cash value through various methods, including taking a loan. A life insurance loan allows individuals to borrow money directly from their insurance company, using the cash value of their permanent life insurance policy as collateral. This approach differs significantly from a traditional bank loan because it leverages an existing policy asset rather than requiring external credit checks or a new application process. Borrowing against a life insurance policy utilizes the policy’s living value, not the death benefit itself.

Understanding Life Insurance Loans

Only certain types of life insurance policies are eligible for loans: those that accumulate cash value over time. Permanent life insurance policies, such as whole life, universal life, and variable universal life, build a cash value component that can be accessed by the policyholder. Term life insurance does not accumulate cash value and therefore does not offer a loan option.

A loan taken against a life insurance policy is not a withdrawal of funds. Instead, the insurance company lends money to the policyholder, with the policy’s cash value serving as collateral. The amount available for a loan is typically a percentage of the accumulated cash value, often up to 90% of the policy’s current cash value.

Even with an outstanding loan, the cash value of the policy generally continues to grow, potentially earning interest or dividends. The loan itself, however, also accrues interest, which adds to the outstanding balance. Funds received from a life insurance loan are generally not considered taxable income, provided the policy remains in force and does not lapse. This tax treatment is a significant distinction.

Managing Your Life Insurance Loan

Interest is charged on a life insurance loan, similar to other forms of credit. The interest rate can be either fixed or variable, with typical annual rates ranging from 3% to 8%, depending on the insurer and the policy terms. Life insurance loans offer a flexible repayment structure. Policyholders usually face no strict repayment schedule or mandatory payments. They can choose to repay the principal and interest at their own pace, make partial payments, or even opt not to repay the loan during their lifetime.

If accrued interest on the loan is not paid, it is typically added to the outstanding loan principal, a process known as capitalization. This causes the loan balance to increase over time, which can impact the policy’s future value. The growth of the policy’s cash value can be influenced by an outstanding loan, depending on the insurer’s method of accounting for borrowed funds. Some insurers use a “direct recognition” method, where the portion of the cash value used as collateral may earn a lower interest rate or dividend. Other insurers may employ a “non-direct recognition” method, where the entire cash value continues to earn interest as if no loan existed.

Impact of Unpaid Loans on Your Policy

Failing to repay a life insurance loan carries several financial consequences for the policy and its beneficiaries. Any outstanding loan balance, including accrued interest, will be directly deducted from the death benefit paid to beneficiaries upon the policyholder’s death. This reduction means beneficiaries will receive a smaller payout than the policy’s face amount.

A significant risk associated with unpaid loans is the potential for the policy to lapse. If the outstanding loan balance, combined with accrued interest, grows to exceed the policy’s cash value, the insurance company may terminate the policy. Insurers typically provide notification to the policyholder before such a lapse occurs, allowing an opportunity to address the situation. If a policy lapses with an outstanding loan, there can be adverse tax implications. The amount of the loan that exceeds the total premiums paid into the policy (the cost basis) may be considered taxable income to the policyholder.

Alternative Ways to Access Policy Cash Value

Policyholders have other methods to access the cash value accumulated within a permanent life insurance policy, distinct from taking a loan. One common alternative is a withdrawal, also known as a partial surrender. Withdrawing funds directly reduces the policy’s cash value and can subsequently decrease the death benefit. Withdrawals are generally treated as a return of the premiums paid into the policy (cost basis) and are typically tax-free up to that amount. Any amount withdrawn that exceeds the cost basis may be subject to ordinary income tax.

Another option is to surrender the entire policy. Policy surrender involves canceling the life insurance coverage in exchange for the policy’s cash surrender value, minus any outstanding loans or applicable fees. This action immediately terminates the life insurance coverage and eliminates the death benefit. When surrendering a policy, if the cash value received exceeds the total premiums paid, the difference is typically considered a taxable gain and is subject to ordinary income tax.