Can You Borrow From Your Life Insurance?

Many life insurance policies offer more than just a death benefit; they can also serve as a financial resource during the policyholder’s lifetime. Certain policies accumulate cash value, which can be accessed through a loan. This allows policyholders to borrow money using their policy’s cash value as collateral, providing a way to tap into accumulated funds without fully surrendering the policy or impacting its long-term coverage.

Types of Policies Eligible for Loans

Only permanent life insurance policies are eligible for loans because they include a cash value component that grows over time. This cash value is a savings-like account within the policy, accumulating through a portion of the premiums paid and earnings. Whole life, universal life, and variable universal life insurance are common examples of policies that build cash value and therefore permit policy loans.

Whole life insurance policies offer guaranteed cash value growth at a fixed rate. Universal life insurance policies offer more flexibility in premium payments and death benefits, allowing cash value to grow based on a declared interest rate. Variable universal life policies link cash value growth to sub-accounts, similar to mutual funds, introducing investment risk but potential for higher returns. Term life insurance policies do not build cash value and therefore do not qualify for policy loans, as they are designed to provide coverage for a specific period without a savings component.

How a Life Insurance Policy Loan Functions

A life insurance policy loan is not a direct withdrawal from the policy’s cash value; rather, it is a loan taken against the cash value, using it as collateral. The funds for the loan come from the insurance company’s general assets, not directly from the policyholder’s cash value account. The cash value continues to grow within the policy, earning interest or investment returns, even while a loan is outstanding.

The policy remains in force during the loan period, provided premiums continue to be paid and the loan balance does not exceed the cash value. Policyholders do not need a credit check to obtain these loans, as the policy’s cash value serves as full collateral. Interest accrues on the outstanding loan balance, similar to other types of loans.

Loan Terms and Policy Impact

Interest rates for life insurance policy loans can be either fixed or variable, ranging from 5% to 8%. These rates are more competitive than those for personal loans or credit cards. Interest accrues daily and is typically charged at the policy anniversary. Policyholders have flexibility regarding loan repayment; there is no fixed schedule, and they can choose to repay the principal and interest at their own pace, or not at all.

While repayment is flexible, an outstanding loan balance, along with any accrued interest, will reduce the policy’s death benefit paid to beneficiaries. For example, if a policy has a $250,000 death benefit and an outstanding loan of $50,000, the beneficiaries would receive $200,000. If the outstanding loan balance, including accrued interest, grows to exceed the policy’s cash value, the policy can lapse. This lapse can lead to the loss of coverage and potential tax consequences.

Obtaining a Policy Loan

The first step in obtaining a policy loan involves determining the available cash value within the policy, which can be done online or by contacting the insurance company directly. Most insurers allow policyholders to borrow up to 90% of their policy’s current cash value. Cash value must accumulate before a loan can be taken, which varies by policy type and premium payments.

Once the loan amount is determined, the policyholder can initiate the request. This involves contacting the insurance company via phone or online portal. Required information includes the policy number and the requested loan amount. After submission, processing times vary from a few business days to a couple of weeks, with funds disbursed directly to the policyholder.

Tax Implications of Policy Loans

Life insurance policy loans are not considered taxable income as long as the policy remains in force, as the IRS views these as borrowing against an asset. However, a loan can become taxable if the policy lapses or is surrendered with an outstanding loan balance, especially if the loan amount exceeds the policy’s basis (total premiums paid minus any dividends received). In such cases, the difference between the outstanding loan balance and the policy’s basis may be treated as taxable income.

The Modified Endowment Contract (MEC) designation is governed by Internal Revenue Code Section 7702A. A policy becomes an MEC if it fails the “seven-pay test,” where premiums paid within the first seven years exceed IRS limits. If classified as an MEC, loans and withdrawals are taxed on an income-first basis (Last-In, First-Out, or LIFO), meaning any gain is taxed before premium return. Distributions, including loans, from an MEC taken before age 59½ may be subject to a 10% federal penalty tax on the taxable portion. Interest accrued on policy loans is not tax-deductible.