Can You Borrow Against Universal Life Insurance?

Universal life (UL) insurance is a type of permanent life insurance that offers lifelong coverage and includes a cash value component. This feature allows the policy to build financial value over time, unlike term life insurance which does not accumulate cash value. A key advantage of UL insurance is the ability to borrow against this cash value. This offers a flexible way to access funds during your lifetime, distinguishing it from policies solely focused on a death benefit. The cash value can serve as a financial resource for various needs.

Understanding Policy Loans

A universal life insurance policy loan is not a direct withdrawal of your cash value but rather a loan provided by the insurance company, using your policy’s cash value as collateral. The funds generally come from the insurer’s general account, not directly from your policy’s cash value. This often eliminates the need for credit checks or income verification typically required for traditional loans, making access to funds relatively simple and private.

The amount you can borrow is directly related to your policy’s accumulated cash value. Insurers typically allow policyholders to borrow up to a significant percentage of this value, often around 90% or 95% of the cash surrender value. However, a sufficient amount of cash value must remain in the policy to ensure continued coverage and to cover ongoing policy fees and charges. It often takes several years for a UL policy to build enough cash value to make borrowing a meaningful option.

Interest accrues on the outstanding loan balance, and the interest rate can be fixed or variable, depending on the specific policy terms. Policy loan interest rates are typically competitive, often ranging between 5% and 8%. Even with an outstanding loan, the unborrowed portion of your policy’s cash value continues to earn interest or grow according to the policy’s terms.

While the cash value continues to grow, the loaned amount typically does not benefit from any market-linked returns, which could reduce the overall growth potential. The terms and conditions, including how interest is calculated and how the cash value continues to grow with an active loan, are outlined in your policy documents. The flexibility of these loans, including the absence of a strict repayment schedule, distinguishes them from many other borrowing options.

How a Loan Affects Your Policy

An outstanding policy loan directly impacts your universal life insurance benefits. Any outstanding loan balance, including accrued and unpaid interest, will be deducted from the death benefit paid to your beneficiaries if the insured dies before the loan is fully repaid. This reduction can significantly diminish the financial support intended for your loved ones. The loan creates a lien against the death benefit, ensuring the insurer recovers the borrowed funds.

While the cash value remains within the policy and continues to earn interest, the loan effectively creates a lien against it. This means the available cash value for other purposes, such as future withdrawals or surrenders, is reduced by the outstanding loan amount. The continued growth of the cash value is important because it supports the policy’s ongoing charges, such as the cost of insurance and administrative fees.

A significant risk associated with policy loans is the potential for policy lapse. If the loan and its accrued interest grow to a point where they exceed the policy’s cash surrender value, the policy can lapse. This occurs because the policy’s remaining cash value becomes insufficient to cover its internal costs. When a policy lapses, coverage terminates, and the death benefit is no longer available. A lapsed policy with an outstanding loan can also trigger unexpected tax consequences.

If a policy lapses or is surrendered with an outstanding loan, the policyholder may face a tax bill on the amount of gain in the policy. The Internal Revenue Service (IRS) considers the difference between the outstanding loan amount (plus any additional gains) and the policy’s basis as taxable income. The policy’s basis refers to the total premiums paid into the policy minus any dividends received. This can result in a significant taxable event, as the “gain” is taxed as ordinary income, not at potentially lower capital gains rates.

Managing Your Policy Loan

Managing a universal life insurance policy loan involves understanding the flexible repayment options and the implications of non-repayment. Policyholders have the flexibility to repay the loan in full, make partial payments, or choose not to repay it at all. Unlike traditional loans, there is no mandatory repayment schedule, offering considerable financial adaptability. However, it is generally recommended to repay the loan to protect the policy’s value and death benefit.

Any repayments made on the loan directly restore the policy’s cash value and, consequently, increase the death benefit back towards its original amount. Full repayment ensures the death benefit is restored to its full value, and no further interest accrues on the loan. This restoration allows policyholders to regain the full protection and financial accumulation of their policy.

Monitoring the loan is important to prevent policy lapse, especially as unpaid loan interest can accrue and compound over time, potentially eroding the cash value. Policyholders should regularly review their policy’s cash value, often through annual illustrations provided by the insurer, to ensure it remains sufficient to cover the outstanding loan and accrued interest. If interest rates rise significantly, increasing repayments can help maintain the policy’s safety.

The tax implications of a policy lapse or surrender with an outstanding loan require careful consideration. If the policy lapses or is surrendered with an outstanding loan balance that exceeds the policy’s basis (premiums paid less dividends received), the excess amount is considered taxable income by the IRS. This can create a significant and unexpected tax liability. Consulting with a tax professional is advisable to understand specific tax consequences.