Can You Borrow From Life Insurance?

Borrowing from a life insurance policy can be a viable financial option for policyholders. This process allows individuals to access funds during their lifetime, leveraging the accumulated value within certain types of policies. Not all life insurance policies offer this feature, as it is contingent on the policy building a cash value component. Understanding how these loans function and their potential implications is important.

Life Insurance Policies That Allow Borrowing

Life insurance policies are broadly categorized into two main types: term life and permanent life. A fundamental distinction between these types lies in their ability to accumulate “cash value.” Cash value represents a savings component that grows within a permanent life insurance policy over time. This value typically accumulates as a portion of each premium payment is allocated to it. The accumulated cash value grows on a tax-deferred basis, offering a source of funds for policyholders.

Policies that build cash value and therefore permit borrowing include Whole Life, Universal Life, and Variable Universal Life. Whole life insurance offers a guaranteed death benefit and cash value growth at a predictable rate, with fixed premium payments. Universal life insurance provides more flexibility in premium payments and death benefit adjustments, with its cash value growing based on an interest rate set by the insurer. Variable Universal Life (VUL) policies allow the cash value to be invested in various sub-accounts, similar to mutual funds, offering potential for higher growth but also increased risk due to market fluctuations.

In contrast, term life insurance policies do not build cash value. These policies provide coverage for a specific period, such as 10, 20, or 30 years, and typically have lower premiums than permanent policies.

How Life Insurance Loans Function

When a policyholder takes a loan from their life insurance, they are not actually withdrawing their own accumulated cash value directly. Instead, they are borrowing money from the insurance company, with the policy’s cash value serving as collateral for the loan. The cash value generally continues to earn interest or dividends, even while the loan is outstanding. No credit check is required to obtain a life insurance policy loan, as the loan is secured by the policy’s own value.

The loan principal is usually limited to a certain percentage of the policy’s cash value, often up to 90%. Interest accrues on the outstanding loan balance, similar to other types of loans. Interest rates on life insurance loans typically range from 5% to 8%, which can be lower than rates for personal loans or credit cards. If the interest is not paid, it is often added to the loan balance, causing the total amount owed to increase over time.

Repayment of a life insurance loan is often flexible, with no strict repayment schedule or mandatory payments. Policyholders can choose to repay the loan at their own pace, or they can opt not to repay it at all during their lifetime. However, leaving the loan unpaid will have consequences, primarily affecting the death benefit.

Key Considerations Before Borrowing

Borrowing against a life insurance policy carries several important financial implications. A significant consequence is the impact on the death benefit. Any outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries upon the policyholder’s death.

Policy loans can also affect the growth and performance of the cash value itself. While the cash value generally continues to earn interest, the portion used as collateral for the loan may not earn at the same rate, potentially slowing the overall growth of the policy’s cash value. For policies with investment components, like Variable Universal Life, borrowing can impact the allocation and performance of the underlying investments. This can diminish the long-term compounding potential within the policy.

A risk associated with life insurance loans is the potential for policy lapse. If the loan balance, combined with accrued interest, grows to exceed the policy’s cash value, the policy can lapse. This means the policyholder loses their life insurance coverage, and the policy terminates. Maintaining premium payments and managing the loan balance are crucial to prevent a lapse.

Should a policy lapse with an outstanding loan, specific tax implications may arise. The amount of the loan, up to the policy’s gain, may become taxable income to the policyholder. This can result in an unexpected tax bill, even if no cash was directly received at the time of lapse. The Internal Revenue Code treats certain policy transactions, including lapsing with an outstanding loan, as a distribution of funds that could trigger tax liability on any gains. Policyholders should weigh the interest charged on the loan against the potential growth the cash value would have achieved if it remained fully invested within the policy.