Can You Borrow Against Whole Life Insurance?

Whole life insurance provides coverage for the duration of an individual’s life, offering a guaranteed death benefit to beneficiaries. Beyond this protective component, whole life policies also feature a savings element known as cash value. This cash value grows over time on a tax-deferred basis, creating an accessible financial resource for the policyholder during their lifetime. The accumulation of cash value distinguishes whole life insurance from term life insurance, which only offers a death benefit for a specified period and does not build cash value.

Understanding Whole Life Insurance Loans

Borrowing against a whole life insurance policy involves taking a loan directly from the insurance company, using the policy’s accumulated cash value as collateral. This differs from withdrawing funds, as the cash value remains within the policy and continues to grow. The cash value acts as a secure asset, minimizing risk for the insurer. Policyholders do not undergo a credit check or a lengthy approval process.

The amount available for a loan is typically a percentage of the cash surrender value, often ranging from 90% to 95%. It can take several years for a policy to accrue sufficient cash value for a substantial loan. Interest rates on these loans can be fixed or variable, as specified in the policy contract, and generally range from 5% to 8%. The insurer charges interest because they forgo the investment returns the collateralized cash value would have generated.

The cash value continues to earn interest and potentially dividends even while a loan is outstanding, though some policies may adjust dividend payments on the collateralized portion. The loan does not appear on credit reports, offering a private and often more affordable financing option than many traditional loans. There are no restrictions on how the borrowed funds can be used.

Repayment and Policy Implications

Loans taken against a whole life insurance policy offer flexible repayment. There is no strict repayment schedule; policyholders can repay the loan at their own pace, or not at all. However, interest accrues on the outstanding loan balance. If not paid, this interest is typically added to the principal, causing the loan balance to grow.

If the loan, including accrued interest, is not repaid before the insured’s death, the outstanding balance will be deducted from the death benefit paid to beneficiaries. A significant risk arises if the outstanding loan balance and accrued interest grow to exceed the policy’s cash surrender value. In such a scenario, the policy could lapse.

A policy lapse due to an unpaid loan can trigger tax consequences. If the policy terminates with an outstanding loan, any amount of the loan exceeding the premiums paid into the policy may be considered taxable income. The Internal Revenue Service (IRS) may treat the unpaid loan as a distribution, and the gain (cash value minus premiums paid) becomes taxable as ordinary income. This can result in an unexpected tax bill.

Tax and Other Considerations

Loans taken from a whole life insurance policy are generally not considered taxable income, as they are viewed as debt rather than a withdrawal of earnings. This tax-free treatment holds as long as the policy remains in force. However, specific rules apply if a policy is classified as a Modified Endowment Contract (MEC).

A whole life policy becomes a MEC if premiums paid exceed certain IRS limits, typically determined by a “7-pay test” within the first seven years. Once designated as a MEC, this classification is irreversible. For MECs, loans are treated differently for tax purposes; they are considered distributions of gain first, meaning any earnings are taxed as ordinary income before the principal. If the policyholder is under age 59½, these taxable distributions may also be subject to a 10% early withdrawal penalty.

Outstanding policy loans can also impact dividends. Some insurers use a “direct recognition” method, where the dividend rate applied to the loaned portion of the cash value may differ from the rate applied to the unloaned portion. This can reduce the amount of dividends credited to the policy for the collateralized portion. Any outstanding loan balance at the time of the insured’s death will reduce the final death benefit paid to beneficiaries.