Can You Borrow Against Your Life Insurance?

Life insurance is a contract where an insurer pays a sum to beneficiaries upon the insured’s death. Beyond the death benefit, certain policies accumulate cash value over time. This cash value can become a financial resource for the policyholder during their lifetime. This article explains how borrowing against a life insurance policy works, detailing qualifying policies, loan mechanics, and tax considerations.

Policies That Allow Loans

Not all life insurance policies build cash value, a prerequisite for a policy loan. Term life insurance, for instance, provides coverage for a specific period, such as 10, 20, or 30 years, and does not include a cash value component. Consequently, term life policies do not allow for policy loans.

Permanent life insurance policies, such as whole life, universal life, and variable universal life, are designed to build cash value over time. This cash value grows from a portion of the premiums paid, along with any interest or investment gains. This accumulated cash value serves as collateral for a loan.

Understanding a Life Insurance Loan

A life insurance policy loan differs from a bank loan or a direct cash withdrawal. It is a loan provided by the insurance company, with your policy’s cash value as collateral. The cash value remains within the policy, continuing to grow tax-deferred, though the loan balance may affect policy performance.

Because the loan is secured by the policy’s cash value, a credit check is not required, and there is no approval process. The insurance company has a built-in mechanism to recover the loan amount. If the loan, including any accrued interest, is not repaid before the insured’s death, the outstanding balance will be deducted from the death benefit paid to the beneficiaries.

Interest accrues on the loan balance, similar to other types of loans. This interest is added to the loan’s principal if not paid periodically, increasing the total outstanding amount.

Loan Mechanics and Repayment

Interest rates for life insurance policy loans vary, often ranging from 5% to 8%, and may be fixed or variable depending on the policy terms. A notable feature of these loans is the flexibility in repayment; policyholders are not bound by a strict repayment schedule and can repay the loan at their own pace, or choose not to repay it at all during their lifetime. However, if interest payments are not made, the unpaid interest is added to the principal balance, which can cause the loan to grow significantly.

The process of obtaining a loan involves contacting the insurance provider and completing the necessary forms. While the exact timeframe can vary, funds are disbursed within a few days to a few weeks after the application is submitted.

Tax Considerations and Policy Lapse

Policy loans are not considered taxable income as long as the life insurance policy remains in force. This tax-favored treatment applies because the loan is viewed as borrowing your own money, with the policy’s cash value serving as collateral. This is distinct from a withdrawal, which could be taxable if it exceeds the amount of premiums paid into the policy.

A risk associated with life insurance loans is the potential for policy lapse. If the outstanding loan balance, including accumulated interest, grows to exceed the policy’s cash value, the policy can terminate. When a policy lapses with an outstanding loan, the loan amount, up to the amount of gain in the policy, can become taxable income to the policyholder in the year of lapse. This unexpected tax liability can be substantial, as it is treated as if the policyholder received income from the policy to repay the loan. Policyholders should regularly monitor their policy’s cash value and loan balance to prevent an unintended lapse and avoid adverse tax consequences.