Can You Borrow From a Term Life Insurance Policy?

Life insurance offers a death benefit to beneficiaries upon the insured’s passing. A common question arises regarding its flexibility, specifically the ability to access funds during one’s lifetime. Understanding how different types of policies function is important when considering options for accessing policy value.

Term Life Insurance and Cash Value

Term life insurance provides coverage for a specific period, such as 10, 20, or 30 years. This type of policy offers financial protection for a defined duration, aligning with temporary needs. Term life policies are generally more affordable than permanent options because they focus solely on providing a death benefit without building any additional value. Term life insurance policies do not accumulate cash value. Cash value is a savings component that grows within a life insurance policy over time, separate from the death benefit. Since term life insurance lacks this cash value component, there is no accumulated fund from which a policyholder can borrow.

Policies That Allow Borrowing

While term life insurance does not allow for borrowing, permanent life insurance policies do provide this flexibility. These include whole life insurance and universal life insurance. These permanent policies offer coverage for the insured’s entire lifetime, unlike term policies that expire after a set period. A key feature of permanent life insurance is its cash value component. As premiums are paid, a portion contributes to this cash value, which grows on a tax-deferred basis over the policy’s life. This accumulating cash value creates a financial reserve that the policyholder can access. Policy loans are made against this accumulated cash value, which serves as collateral for the loan. It can take several years for the cash value to grow sufficiently for a meaningful loan.

How Life Insurance Loans Work

Borrowing from a permanent life insurance policy’s cash value is distinct from making a withdrawal. When a loan is taken, the policy’s cash value acts as collateral, and the funds are lent by the insurance company. The cash value continues to grow within the policy, even with an outstanding loan. Policy loans typically do not require a credit check or formal approval, offering a straightforward way to access funds. The loan amount is generally not considered taxable income, as it is viewed by the IRS as a debt against the policy’s value rather than a distribution of earnings. If the policy lapses or is surrendered with an outstanding loan, the amount borrowed that exceeds the premiums paid can become taxable income. Interest accrues on the outstanding loan balance, with rates typically ranging from 5% to 8%, which can be fixed or variable. If interest is not paid, it is added to the loan principal, increasing the total amount owed. Repayment terms for life insurance loans are often flexible, allowing policyholders to repay the loan on their own schedule or not at all during their lifetime. Any outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries when the insured passes away. If the loan balance, along with accumulated interest, grows to exceed the policy’s cash value, the policy could lapse. A policy lapse would terminate coverage and could trigger unexpected tax liabilities on any gains.