Can You Borrow From Basic Life Insurance?
Unlock the truth about borrowing from life insurance. Discover how policy loans work, their implications, and what you need to consider.
It is possible to borrow from a life insurance policy, but this option depends entirely on the specific type of policy held. Certain life insurance policies are designed to accumulate a cash value over time, which can then serve as a source of funds through a loan. However, it is important to understand the distinctions between policy types before considering a loan, as not all life insurance offers this feature.
Life Insurance Policy Types and Cash Value
Life insurance policies fall into two main categories: term life and permanent life insurance. These categories differ significantly in their structure, particularly regarding the accumulation of cash value. The presence of cash value is a prerequisite for borrowing against a policy.
Term life insurance provides coverage for a specific period, such as 10, 20, or 30 years. It is designed purely for protection, offering a death benefit to beneficiaries if the insured passes away within the specified term. Term life policies do not build any cash value and, therefore, do not allow for policy loans.
In contrast, permanent life insurance policies, such as whole life, universal life, and variable universal life, include a cash value component. This cash value is an accumulation of funds within the policy that grows over time. A portion of each premium payment contributes to this cash value, which then accumulates interest or earns investment returns, on a tax-deferred basis.
Whole life insurance offers guaranteed cash value growth at a fixed rate, ensuring predictable accumulation. Universal life insurance provides more flexibility, allowing adjustments to premiums and death benefits, and its cash value grows based on an interest rate set by the insurer, often with a guaranteed minimum. Variable universal life insurance allows the policyholder to invest the cash value in various sub-accounts, similar to mutual funds, which offers potential for higher returns but also carries market risk.
The Mechanics of a Policy Loan
Once a permanent life insurance policy has accumulated sufficient cash value, the policyholder can consider taking a loan. A policy loan is not a withdrawal of the cash value itself. Instead, the insurance company lends the policyholder money, using the policy’s cash value as collateral. The cash value remains intact within the policy, continuing to earn interest or investment returns, though the portion equal to the loan effectively becomes tied up.
The amount available for a loan is limited to a percentage of the accumulated cash value, ranging from 90% to 95%. The insurer sets an interest rate for the loan, which can be fixed or variable, ranging between 5% and 8%. This interest accrues on the outstanding loan balance, and if not paid, it is added to the principal, causing the loan balance to grow over time.
Repayment terms for life insurance policy loans are flexible. There is no fixed repayment schedule, meaning policyholders can choose to repay the loan over time, pay only the interest, or even make no repayments at all during their lifetime. However, interest continues to accumulate as long as the loan remains outstanding.
Impact on Your Policy and Beneficiaries
Having an outstanding policy loan carries direct consequences for both the life insurance policy and its intended beneficiaries. Policyholders should understand these implications to avoid unintended outcomes.
A primary impact of an outstanding loan is a reduction in the death benefit. If the policyholder passes away with an unpaid loan balance, including any accrued interest, the insurance company will subtract this total amount from the death benefit paid to the beneficiaries. This means the beneficiaries will receive less than the policy’s stated face value.
There is also a risk of policy lapse if the loan is not managed carefully. If the outstanding loan balance, along with accumulated interest, grows to exceed the policy’s cash value, the policy can terminate. Should a policy lapse under these conditions, the outstanding loan amount may be considered taxable income to the policyholder. Any gain in the policy, defined as the cash value exceeding the total premiums paid (cost basis), can become taxable as ordinary income. For policies classified as Modified Endowment Contracts (MECs), loans and withdrawals are subject to different tax rules, taxed as income first and potentially incurring a 10% federal tax penalty if the policyholder is under age 59½.
An outstanding loan can diminish the policy’s overall cash value and its ability to grow further. The portion of the cash value that collateralizes the loan is “tied up” and may not actively participate in the policy’s interest crediting or dividend payments. This can slow down future cash value accumulation and reduce the long-term financial benefits the policy might otherwise provide.