Can You Borrow Against a Term Life Insurance Policy?

Life insurance serves as a financial safety net, providing funds to beneficiaries upon the insured’s death. While this basic purpose is understood, questions often arise regarding accessing these funds during the policyholder’s lifetime, particularly through borrowing. The ability to borrow against a life insurance policy depends entirely on the type of policy held. Term life insurance, designed for temporary coverage, does not offer this feature. However, other forms of life insurance policies do build a component known as cash value, which can be utilized for loans. Understanding the distinctions between these policy types is essential for anyone considering life insurance for both protection and potential liquidity.

The Nature of Term Life Insurance

Term life insurance provides coverage for a specific, predetermined period, known as the “term.” This period can range from a single year to 30 years or longer. If the insured individual dies within this specified term, a death benefit is paid to the designated beneficiaries. The primary function of term life insurance is to offer death benefit protection, ensuring financial security for dependents during a period of significant financial responsibility, such as raising a family or paying off a mortgage.

A defining characteristic of term life insurance is its lack of a savings or investment component. Term policies do not accumulate cash value over time, meaning there is no fund against which a policyholder can borrow. Therefore, term life insurance cannot be used as a source for policy loans.

The premiums for term life insurance are more affordable compared to permanent life insurance, especially when purchased at a younger age. This affordability stems from its temporary nature and the absence of a cash value feature. Policyholders pay for the death benefit coverage, and if they outlive the term, the coverage simply ends unless it is renewed or converted to a different policy type.

The Nature of Cash Value Life Insurance

Cash value life insurance, often referred to as permanent life insurance, offers lifelong coverage and includes a savings or investment component. This distinguishes it from term life insurance, which is purely for death benefit protection. As premiums are paid, a portion goes towards the cost of insurance, and another portion contributes to the policy’s accumulating cash value. This cash value grows over time, potentially on a tax-deferred basis, providing a living benefit that policyholders can access.

There are several types of cash value policies, each with distinct features regarding how cash value accumulates. Whole life insurance, for example, offers guaranteed cash value growth at a fixed interest rate and fixed premiums. Universal life insurance provides more flexibility, allowing adjustments to premium payments and death benefits, with cash value growth often tied to market interest rates. Variable universal life and indexed universal life policies also build cash value, with their growth linked to investment performance or market indices, offering potential for higher returns but also greater risk.

The accumulated cash value can serve various financial purposes for the policyholder. It can be accessed through withdrawals or, more commonly, through policy loans. This accessible cash value provides a source of funds that can be used for emergencies, educational expenses, or other financial needs during the insured’s lifetime. The ability to access this cash value is a primary reason individuals choose permanent life insurance over term life.

Understanding Life Insurance Policy Loans

A life insurance policy loan is a way to access the accumulated cash value within a permanent life insurance policy. This type of loan is not a traditional loan from a bank or financial institution. Instead, it is an advance from the insurer, with the policy’s cash value serving as collateral. This means that the policyholder is borrowing their own money, with the policy guaranteeing the repayment.

The process of obtaining a policy loan is straightforward, often requiring only a request form from the insurer. There is no credit check, and the loan approval is based on the available cash value, not the policyholder’s creditworthiness. Policyholders can borrow up to 90% of their policy’s current cash value.

Repayment of a policy loan offers flexibility; there is no strict repayment schedule, and policyholders can choose to repay the loan at their convenience, or not at all. However, interest accrues on the outstanding loan balance, at a rate between 5% and 8%, which is often lower than personal loans or credit cards. If the loan and its accrued interest are not repaid, the outstanding balance will reduce the death benefit paid to beneficiaries upon the insured’s death.

An implication arises if the outstanding loan balance, including interest, exceeds the policy’s cash value. In such a scenario, the policy can lapse, potentially leading to adverse tax consequences. If a policy lapses with an outstanding loan, the loan amount that exceeds the premiums paid into the policy may be treated as taxable income by the IRS. This tax liability can be substantial, especially if the policy has accumulated gains.

If the policy is classified as a Modified Endowment Contract (MEC), policy loans are treated differently for tax purposes. A policy becomes an MEC if it is overfunded, meaning premiums paid exceed certain IRS limits, specifically failing the “seven-pay test.” For MECs, loans are considered distributions of gain first, which are taxable as ordinary income. If the policyholder is under age 59½, a 10% early withdrawal penalty may apply to the taxable portion of the loan from an MEC, similar to penalties on early retirement account withdrawals.