Can You Borrow From a Term Life Insurance Policy?

It is not possible to borrow from a term life insurance policy. This limitation stems from the fundamental design of term life insurance, which does not include a cash value component. Policy loans are available only through permanent life insurance policies that accumulate cash value over time.

Understanding Term Life Insurance

Term life insurance provides coverage for a specific period, often ranging from 10 to 30 years. Its primary purpose is to deliver a death benefit to beneficiaries if the insured person passes away within that defined term.

Term life insurance lacks a savings or investment component. Premiums paid for a term policy secure coverage for the specified duration but do not build up any cash value that the policyholder can access while alive. This design makes term life insurance a more affordable option compared to permanent policies, as it focuses solely on providing a death benefit.

Understanding Permanent Life Insurance and Cash Value

In contrast to term life, permanent life insurance policies, such as whole life, universal life, variable universal life, and indexed universal life, are designed to provide lifelong coverage. These policies include a cash value component that accumulates over time. This cash value grows on a tax-deferred basis, meaning earnings are not taxed until they are withdrawn.

The cash value within a permanent life insurance policy is a portion of the premium payments allocated to a separate account. This account grows through guaranteed interest rates, investment returns, or dividends, depending on the policy type. The accumulated cash value serves as a living benefit, which policyholders can access through withdrawals or policy loans. The growth of this cash value is subject to Internal Revenue Code Section 7702, which sets criteria for tax-advantaged status.

How Life Insurance Policy Loans Work

Taking a loan from a permanent life insurance policy involves borrowing money from the insurer, using the policy’s accumulated cash value as collateral. This process differs from a withdrawal, as the loan does not reduce the policy’s cash value directly but rather creates a lien against it. Policy loans are straightforward to obtain, requiring no credit checks, as the policy itself secures the loan.

The amount available for a loan is a percentage of the cash value, commonly up to 90%. While there is no strict repayment schedule for policy loans, interest accrues on the outstanding balance. Interest rates can be fixed or variable, ranging from 5% to 8%. Any outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries if the insured passes away before the loan is fully repaid.

Implications of Unpaid Policy Loans

While policy loans offer flexibility, not repaying them can lead to significant consequences. If the outstanding loan balance, including accrued interest, grows to exceed the policy’s cash value, the policy may lapse. This means the insurance coverage ends, and the policyholder loses the death benefit and any remaining cash value.

A policy lapse with an outstanding loan can also trigger adverse tax implications. Policy loans are not considered taxable income as long as the policy remains in force. However, if a policy lapses or is surrendered with an unpaid loan, the loan amount exceeding the policyholder’s cost basis (premiums paid) may become taxable as ordinary income. If the policy is classified as a Modified Endowment Contract (MEC) under Internal Revenue Code Section 7702A due to overfunding, loans and withdrawals are taxed, and an additional 10% penalty may apply if the policyholder is under age 59½.