Financial Planning and Analysis

Can You Borrow Against a Life Insurance Policy?

Unlock your life insurance policy's potential. Understand how to borrow against its cash value, navigate the process, and manage repayment.

Policy loans are a unique feature offered by certain life insurance products that build cash value over time. This access to funds can serve as a flexible financial resource for policyholders. This financial option is not available with all types of policies.

Understanding Policy Loans

A life insurance policy loan enables you to borrow money directly from your insurance company, using your policy’s accumulated cash value as collateral. This differs from a withdrawal, where you permanently remove funds from the policy’s cash value, potentially reducing the death benefit. With a loan, the cash value secures the borrowed amount, and the policy remains in force, continuing to provide coverage.

This borrowing feature is exclusive to permanent life insurance policies, such as whole life, universal life, and variable universal life insurance, which build cash value over time. Term life insurance policies, which provide coverage for a specific period and do not accumulate cash value, do not offer this loan option. The loan is sourced directly from the insurance company, not a third-party lender. Your policy’s cash value acts as the sole collateral, meaning no credit checks or extensive approval processes are needed.

Features of Policy Loans

Interest is charged on a policy loan, with rates typically ranging from 5% to 8%. These rates can be fixed or variable, and interest often compounds if not paid. This interest is paid back to the insurance company, not to your policy’s cash value directly.

Policy loans have a flexible repayment structure. There is generally no fixed repayment schedule, and policyholders are not obligated to make regular payments. You can choose to repay the loan at your convenience, or even opt not to repay it at all during your lifetime. However, any outstanding loan balance, including accrued interest, will directly reduce the death benefit paid to your beneficiaries upon your passing.

The portion of your cash value used as collateral for the loan typically continues to earn interest or dividends, though the earning rate might be adjusted. This means your policy’s underlying value can continue to grow even with an outstanding loan. Policy loans are generally treated as tax-free transactions, provided the policy remains in force. The Internal Revenue Service (IRS) views these funds as a loan against an asset, not as taxable income, as long as the loan amount does not exceed the policy’s basis, which is generally the total premiums paid.

Obtaining a Policy Loan

Initiating a policy loan request typically involves contacting your insurance company directly. This can be done via phone, online portal, or mail.

When requesting a loan, the insurance company will require specific information. This includes your policy number, the loan amount, and your preferred method for receiving funds, such as direct deposit or a check. Identity verification will also be part of this process.

Since the loan is secured by your policy’s cash value, no credit check or lengthy approval process is required. The primary requirement is that your policy has accumulated sufficient cash value to support the requested loan amount. The maximum loan amount is typically up to 90% of the policy’s cash value, though the exact percentage can vary by insurer. Funds are usually disbursed within a few business days.

Handling Your Policy Loan

While policy loans offer flexible repayment, interest continuously accrues on the outstanding balance. If this interest is not paid, it is added to the principal loan amount, causing the overall loan balance to grow. This increasing loan balance can eventually impact the stability of your policy.

A consequence of neglecting a policy loan is the risk of policy lapse. If the outstanding loan balance, including accrued interest, grows to exceed the policy’s cash value, the insurance company may terminate the policy. Should a policy lapse with an outstanding loan, the portion of the loan that exceeds the policy’s cost basis (generally the total premiums paid) can become taxable income to the policyholder. This unexpected tax liability can be substantial, particularly if the loan has grown significantly.

For policies classified as Modified Endowment Contracts (MECs) under federal tax law, loans are treated differently. If a policy becomes a MEC, loans are taxed on a “last-in, first-out” (LIFO) basis, meaning earnings are considered withdrawn first and are immediately taxable, potentially incurring a 10% penalty if the policyholder is under age 59½. Regardless of MEC status, any outstanding loan continues to reduce the death benefit payable to beneficiaries. Policyholders retain control over the loan and can make partial repayments or repay the full amount at any time, which restores the policy’s full cash value and death benefit.

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