Can I Take a Loan Out on My Life Insurance?
Learn how your life insurance policy can serve as a financial resource. Understand the practicalities and consequences of accessing its value.
Certain life insurance policies can provide a source of funds through a loan, offering a way to access liquidity from a policy’s accumulated value. This option allows policyholders to leverage their insurance asset for various financial needs during their lifetime. Understanding the structure and implications of such loans is important for anyone considering this financial tool.
Understanding Policy Eligibility
Life insurance policies that allow for loans are those which accumulate a “cash value” component. This cash value represents a portion of the premiums paid, along with any accrued interest or investment gains, that grows within the policy over time. It functions as a savings component that the policyholder can access during their lifetime. Only permanent life insurance policies, such as whole life, universal life, variable universal life, and indexed universal life, build this cash value.
A portion of each premium payment is allocated to the cash value component, allowing it to increase over the policy’s duration. Term life insurance policies, conversely, do not accumulate cash value because they provide coverage for a specific period without a savings element, and therefore, they do not offer a loan option. It typically takes several years for sufficient cash value to build within a permanent policy before it can be used for a loan, with some policies requiring around 5 to 10 years to accumulate enough value for borrowing.
Mechanics of a Life Insurance Loan
A loan from a life insurance policy is taken from the policy’s accumulated cash value. The cash value within the policy serves as collateral for the loan, which means there is no credit check or extensive approval process. The loan amount is usually limited to a certain percentage of the cash value, commonly 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. The interest rate can be fixed or variable, often ranging from 5% to 8%. Despite taking a loan, the cash value of the policy may continue to grow through interest or dividends, as the funds are not physically removed from the policy but rather used as collateral for the loan. The policy generally remains in force as long as premiums are paid and the outstanding loan balance, including accrued interest, does not exceed the policy’s cash value.
Impact on Policy and Repayment
Unlike conventional loans, a life insurance policy loan typically does not have a mandatory repayment schedule. Policyholders have flexibility in how and when they choose to repay the loan, or they can opt not to repay it at all during their lifetime. However, interest continues to accrue on the outstanding loan balance, and this accumulated interest can increase the total amount owed.
An outstanding loan impacts the policy’s death benefit. If the loan, plus any accrued interest, is not repaid before the insured’s passing, the outstanding balance will be deducted from the death benefit paid to the beneficiaries. This reduces the amount their loved ones will receive. A significant risk arises if the outstanding loan balance, along with accrued interest, grows to exceed the policy’s cash value. In such a scenario, the policy can lapse, meaning coverage terminates.
A policy lapse with an outstanding loan can lead to unexpected tax consequences. The Internal Revenue Service (IRS) may consider the portion of the loan that exceeds the policyholder’s “cost basis” (premiums paid minus distributions received) as taxable income. This taxable amount represents the investment gains within the policy. For instance, if a policyholder paid $40,000 in premiums and the cash value grew to $55,000, but an outstanding loan caused a lapse, the $15,000 gain could become taxable. This can occur even if no net cash value remains in the policy.
Repayment options include making partial payments, paying only the interest, or allowing the loan to grow. Policyholders should regularly monitor their loan balance relative to their cash value and consider making interest payments to prevent the loan from increasing to a point that jeopardizes the policy’s in-force status.