Can You Borrow From a Life Insurance Policy?

Life insurance policies primarily provide a financial safety net for beneficiaries upon the policyholder’s passing. Certain types of policies offer a feature allowing policyholders to access accumulated funds during their lifetime. This capability, known as a policy loan, enables individuals to borrow against the cash value that has built up within their life insurance coverage. Understanding how these loans function is important for those exploring this financial option.

Policy Types and Eligibility

The ability to borrow from a life insurance policy hinges on the type of policy owned, specifically whether it accumulates cash value. Permanent life insurance policies are designed to build cash value over time, making them eligible for policy loans. These include whole life, universal life, variable universal life, and indexed universal life insurance. A portion of the premium payments for these policies is allocated to a separate account that grows on a tax-deferred basis, creating this accessible cash value.

Whole life insurance offers a guaranteed cash value growth rate and a fixed premium, providing predictable accumulation. Universal life insurance provides more flexibility, allowing adjustments to premiums and death benefits, with cash value growth often tied to an interest rate set by the insurer. Variable universal life and indexed universal life policies connect cash value growth to investment performance or market indexes, offering potential for higher returns. Conversely, term life insurance, which provides coverage for a specific period without building cash value, does not allow for policy loans. This distinction is fundamental because the cash value serves as the collateral for any loan taken.

Understanding a Policy Loan

A policy loan is not a direct withdrawal of funds from the policy’s cash value. Instead, it is a loan from the insurance company, with the policy’s cash value serving as collateral. This means the cash value continues to grow, potentially earning interest or dividends, even while a loan is outstanding. The insurance company charges interest on the loan, and these rates can be fixed or variable, typically ranging from 5% to 8%. This interest is paid to the insurance company, not back into the policy’s cash value.

Policyholders can borrow up to 90% of their accumulated cash value. Policy loans do not require a credit check or formal approval, as the loan is secured by the policy’s cash value. Loan proceeds are not considered taxable income, provided the policy remains in force and the loan amount does not exceed the premiums paid into the policy. This tax-free status makes policy loans a flexible financial resource.

The Loan Process

Initiating a life insurance policy loan is generally a straightforward process once sufficient cash value has accumulated. Policyholders typically begin by contacting their insurance provider directly. The insurer will confirm the available cash value and the maximum loan amount that can be taken. This step is important as it may take several years for a policy to build enough cash value to support a meaningful loan.

After determining the eligible loan amount, the policyholder usually completes a loan request form. This form typically requires the policy number, the desired loan amount, and the policyholder’s signature. Funds are disbursed by the insurance company, often within a matter of days. The simplicity and speed of this process make policy loans a convenient option for accessing liquidity.

Managing and Repaying the Loan

Managing a life insurance policy loan involves understanding its ongoing impact and the flexible repayment options. There is typically no strict repayment schedule for a policy loan, offering policyholders considerable flexibility. However, interest continues to accrue on the outstanding loan balance. While repayment is optional, it is generally advisable to repay the loan and accrued interest to maintain the policy’s full value.

An outstanding loan balance directly reduces the death benefit paid to beneficiaries. If the policyholder passes away with an unpaid loan, the outstanding amount, plus any accrued interest, is deducted from the death benefit. If the loan balance, including accrued interest, grows to exceed the policy’s cash value, the policy can lapse. A policy lapse with an outstanding loan can trigger tax consequences, as the untaxed loan amount may then be considered taxable income. This tax liability arises because the loan is no longer viewed as an advance against the policy but as a distribution from a terminated policy.