Can You Borrow Against Term Life Insurance?

Life insurance protects loved ones from financial hardship following an insured individual’s passing. Term life insurance provides coverage for a specific period, such as 10, 20, or 30 years, and pays a death benefit if the insured dies within that term. Can you borrow against term life insurance? No. Term life insurance policies do not accumulate cash value, which is the component necessary for borrowing.

Understanding Term Life Insurance

Term life insurance is temporary, providing coverage for a predetermined period, often chosen to align with financial obligations, such as raising a family or paying off a mortgage. The policy remains in force only for the chosen term, and if the insured outlives this period, the coverage expires without any payout.

The premiums paid for a term life policy primarily cover the cost of the death benefit and administrative expenses. No part of the premium is allocated to a savings or investment component within the policy.

This absence of a cash value is the reason why borrowing against a term life policy is not possible. A cash value component would represent an accumulated savings or investment fund within the policy. Without such a fund, there is no underlying asset to borrow against.

Life Insurance Policies That Allow Borrowing

In contrast to term life insurance, permanent life insurance policies include a cash value component that allows for policy loans. Types such as whole life and universal life insurance provide coverage for a lifetime, as long as premiums are paid. A portion of each premium payment for these policies is allocated to the cash value, which grows tax-deferred.

Borrowing against these policies involves taking a loan from the insurance company, with the policy’s accumulated cash value serving as collateral. The loan is secured by your policy’s value, rather than being a traditional loan based on your credit score. Policy loans do not require a credit check or a formal application process, offering a flexible way to access funds.

Interest accrues on the loan, with rates ranging from 5% to 8%, which can be more competitive than other personal loan options. If the loan, including accrued interest, is not repaid, the outstanding balance will reduce the death benefit. While repayment is flexible, allowing the loan balance to grow too large can lead to the policy lapsing, potentially creating a taxable event if the loan amount exceeds the premiums paid.

Generally, the loan proceeds are not considered taxable income unless the policy is classified as a Modified Endowment Contract (MEC) or if the policy lapses or is surrendered with an outstanding loan. In such cases, any gain in the policy, defined as the amount borrowed exceeding the premiums paid, could become taxable as ordinary income. Interest paid on a life insurance policy loan is not tax-deductible for personal use.

Alternatives for Accessing Funds

Since borrowing against a term life insurance policy is not an option, individuals needing access to funds often explore other financial avenues. Personal loans are a common choice, available from banks, credit unions, and online lenders. These are unsecured loans, meaning they do not require collateral, and interest rates vary significantly based on the borrower’s creditworthiness and the lender’s terms.

Home equity loans or Home Equity Lines of Credit (HELOCs) allow homeowners to borrow against the equity built in their homes. A HELOC acts as a revolving line of credit, similar to a credit card, allowing funds to be drawn as needed up to a set limit. Interest rates for HELOCs are often variable, with national averages recently ranging from 7.75% to over 11% APR, and can fluctuate with market rates. These loans are secured by the home, meaning the property can be at risk if repayment obligations are not met.

Borrowing from a 401(k) or other retirement accounts is another potential source of funds. Many 401(k) plans permit loans up to the lesser of $50,000 or 50% of the vested account balance, with repayment periods of five years. The interest rate is the prime rate plus one or two percentage points, and the interest paid goes back into the borrower’s own retirement account. However, if the loan is not repaid according to the terms, the outstanding balance can be considered a taxable distribution, and a 10% penalty may apply if the borrower is under age 59½.

Credit cards can provide immediate access to funds, but they come with high interest rates, making them a less cost-effective option for substantial borrowing. The average credit card interest rate can range from 20% to over 25% APR, and these rates are variable. For those with assets, secured loans, such as auto title loans or loans secured by savings accounts, offer another alternative. These loans have lower interest rates compared to unsecured options because the collateral reduces the lender’s risk, but they carry the inherent risk of losing the pledged asset if the loan defaults.