Can You Borrow From Universal Life Insurance?
Unlock the potential of your universal life insurance policy by understanding how to borrow against its cash value, its implications, and proper management.
Universal life insurance offers permanent coverage alongside a cash value component that grows over time. This cash value provides a unique financial resource for policyholders. It is possible to borrow from your universal life insurance policy, leveraging its cash value to access liquidity. This feature allows policyholders financial flexibility, but involves specific mechanics and implications that differ from traditional loans. Understanding these aspects is important.
Understanding Universal Life Policy Loans
A loan from a universal life insurance policy is distinct from a typical bank loan or a withdrawal of funds. When you take a loan, you are not actually removing money directly from your policy’s cash value. Instead, the insurance company lends you money from its general account, using your policy’s accumulated cash value as collateral for the loan. This arrangement means your cash value generally continues to earn interest or investment returns, even on the portion that is securing the loan.
Interest accrues on the amount borrowed, with rates typically outlined in the policy documents and often ranging from 1% to 8%. Some policies may offer variable interest rates tied to market conditions, while others have fixed rates. The borrowed funds are generally not considered taxable income, provided the policy remains in force. This tax-free status stems from the Internal Revenue Service (IRS) viewing the transaction as a debt against your policy rather than a distribution of earnings.
Accessing Funds from Your Policy
Obtaining a loan from a universal life policy typically involves a straightforward process, as it does not require credit checks or extensive approval procedures common with other lending options. The primary requirement is that the policy must have accumulated sufficient cash value to support the desired loan amount. Insurers often specify a minimum cash value threshold.
Most insurance companies allow policyholders to borrow a significant percentage of their cash surrender value, commonly up to 90%. To initiate a loan, policyholders generally contact their insurer, complete a loan request form, and specify the amount they wish to borrow. The funds can typically be used for any purpose. It is important to ensure enough cash value remains to cover ongoing policy charges and prevent potential adverse impacts.
How Policy Loans Affect Your Policy
Taking a loan from your universal life insurance policy carries several financial implications that policyholders must consider. Any outstanding loan balance, along with accrued interest, will reduce the death benefit paid to beneficiaries dollar-for-dollar if the loan is not repaid before the insured’s death. This means the net payout to heirs will be less than the policy’s stated death benefit.
Interest is continuously charged on the outstanding loan balance, which can compound over time. A potential risk is “negative arbitrage,” where the interest rate charged on the loan exceeds the rate of return credited to the policy’s cash value. This scenario can erode the cash value over time, even if the policy continues to earn interest on the unborrowed portion.
If the loan balance, including accumulated interest, grows to exceed the policy’s cash value, the policy is at risk of lapsing. A policy lapse with an outstanding loan can trigger a taxable event, as the loan amount exceeding the policyholder’s basis (premiums paid less any tax-free distributions) may be considered taxable income by the IRS.
Managing and Repaying the Loan
Universal life policy loans offer considerable flexibility regarding repayment, as there is typically no mandatory repayment schedule. Policyholders can choose to make regular payments, sporadic payments, or even no payments at all on the loan principal. However, it is generally advisable to at least pay the annual loan interest to prevent it from being added to the principal, which increases the total loan balance and future interest charges.
Proper management of the loan is crucial to avoid negative impacts on the policy. Neglecting repayment can lead to a significant reduction in the death benefit and increases the risk of the policy lapsing, potentially triggering tax consequences.