Can You Borrow From Your Life Insurance Policy?

Life insurance policies offer a unique financial feature beyond providing a death benefit: the ability to borrow against their accumulated value. Certain policies build cash value over time, which policyholders may access as a loan. This provides a flexible source of funds without traditional credit checks or loan applications. Understanding how these loans work, which policies qualify, and their implications is important.

Eligible Life Insurance Policies

Not all life insurance policies allow borrowing. The ability to take a loan is tied to the presence of a cash value component, which represents a portion of premiums paid that grows over time on a tax-deferred basis. Only permanent life insurance policies, designed for lifetime coverage, accumulate this cash value.

Whole life insurance is a permanent policy where the cash value grows at a guaranteed rate, often specified in the policy contract. A portion of each premium payment is allocated to this cash value, which steadily increases over the policy’s life. This predictable growth provides a stable base for potential loans.

Universal life insurance policies also build cash value, with more flexible growth than whole life. Premiums can be adjusted within limits, and cash value growth is tied to an insurer-declared interest rate that can fluctuate. The cash value is reduced by policy charges, such as mortality costs and administrative fees, before interest is credited.

Variable universal life insurance offers another form of cash value accumulation. Here, the cash value is invested in sub-accounts chosen by the policyholder, similar to mutual funds. Cash value growth is not guaranteed and depends on the performance of these underlying investments. This directly impacts the amount available for a loan.

Term life insurance policies, by contrast, provide coverage for a specific period, such as 10, 20, or 30 years. These policies do not build cash value, as premiums primarily cover the cost of insurance for the specified term. Therefore, term life insurance policies do not offer loan features.

The Loan Process and Mechanics

Initiating a loan from a life insurance policy involves a straightforward request to the insurance company. This process does not require a credit check, as the loan is secured by the policy’s cash value. The policyholder borrows from the insurer, using the accumulated value as collateral.

Policyholders can typically borrow a percentage of the policy’s cash surrender value, which is the cash value minus any surrender charges. Insurers commonly allow borrowing up to 90% or 95% of the available cash value.

Interest rates on life insurance policy loans can be either fixed or variable. Fixed rates are set at the time of the loan and remain constant, often ranging from 5% to 8% annually. Variable rates can adjust periodically based on a predetermined index. Interest accrues on the outstanding loan balance.

A life insurance policy loan is not a withdrawal from the cash value. The cash value remains intact within the policy, continuing to grow according to the policy’s terms, though the loan amount is held as collateral. The loan is a debt against the policy, and the insurer charges interest. The policy’s death benefit is temporarily reduced by the outstanding loan amount, including accrued interest.

The cash value that secures the loan may continue to earn interest or dividends. However, the effective rate of return on the net cash value (cash value minus the loan) is often lower than the interest rate charged on the loan. This can lead to a negative arbitrage, where the loan interest rate exceeds the growth rate of the cash value backing the loan.

Understanding Loan Repayment and Policy Impact

Unlike conventional bank loans, life insurance policy loans do not come with strict repayment schedules or mandatory monthly payments. Policyholders have considerable flexibility in how and when they repay the loan principal and interest. Interest continues to accrue on the outstanding loan balance. This flexibility can be a benefit for short-term liquidity needs, but it requires diligent management to prevent negative long-term consequences for the policy.

An outstanding loan, including accrued interest, directly reduces the policy’s death benefit. If the insured passes away with an active loan, the insurance company will deduct the total outstanding loan amount from the death benefit paid to the beneficiaries.

A significant risk with life insurance policy loans is the potential for policy lapse. If the outstanding loan balance, along with accrued interest, grows to exceed the policy’s cash value, the policy can terminate. This is particularly likely if the policyholder stops paying premiums or if the cash value growth cannot keep pace with the accumulating loan interest.

The lapse of a policy with an outstanding loan can trigger unexpected tax implications. If the outstanding loan amount exceeds the policyholder’s cost basis (generally, total premiums paid minus any dividends or prior withdrawals), the difference may be considered taxable income by the Internal Revenue Service (IRS). This occurs because the IRS views the loan as a tax-free distribution up to the policy’s basis; if the policy lapses, any loan amount exceeding the basis becomes taxable as ordinary income.

Proper management of policy loans is paramount to maintaining life insurance coverage and avoiding adverse tax outcomes. Policyholders should regularly monitor their loan balance and accrued interest. Making at least interest-only payments can help prevent the loan from growing too large, safeguarding the policy from unintended lapse and potential tax liabilities.