Can You Borrow Money From a Life Insurance Policy?

Policy Eligibility for Loans

Certain types of life insurance also include a savings component known as cash value. This accumulated cash value is what makes a policy eligible for a loan, as it represents a portion of the premiums paid that grows over time. The ability to borrow against a policy is directly tied to the presence and growth of this cash value.

Whole life insurance is a type of permanent life insurance that features guaranteed cash value accumulation. A portion of each premium payment contributes to this cash value, which grows on a tax-deferred basis at a guaranteed rate.

Universal life insurance policies also build cash value, though their accumulation is more flexible and can be influenced by prevailing interest rates or investment performance, depending on the specific policy structure. Other permanent policies, such as variable universal life insurance, similarly build cash value, but their growth is tied to the performance of underlying investment sub-accounts, introducing potential for greater gains or losses.

Conversely, term life insurance policies do not build cash value. These policies provide coverage for a specific period and do not include a savings component. Therefore, term life insurance policies do not allow policyholders to borrow money against them, as there is no cash value to serve as collateral for a loan. The amount available for a loan from an eligible policy is always based on the accumulated cash value, not the policy’s death benefit.

The Mechanics of Borrowing

When a policyholder takes a loan from a life insurance policy, they are essentially borrowing money using their policy’s accumulated cash value as collateral. This is distinct from a traditional bank loan, as the funds do not come directly from the insurance company’s general assets in the same manner. Instead, the policy’s cash value secures the loan.

Insurance companies typically allow policyholders to borrow up to a certain percentage of their accumulated cash value, commonly ranging from 75% to 95%. A significant advantage of these loans is that they generally do not require a credit check, because the policy’s cash value provides sufficient security for the loan.

Interest accrues on the outstanding loan balance, and the rate can be either fixed or variable, as defined by the policy contract. If the interest is not paid, it typically gets added to the outstanding loan principal, causing the loan balance to grow over time. This compounding effect means the total amount owed can increase significantly if left unaddressed.

Policyholders are usually not required to adhere to a fixed repayment schedule or make regular monthly payments. They can repay the loan at their own pace, make partial payments, or even choose not to repay the loan at all during their lifetime. However, any outstanding loan balance, including accrued interest, will directly reduce the death benefit paid to beneficiaries when the policyholder passes away.

Consequences of Unpaid Loans

An outstanding loan balance on a life insurance policy carries specific financial consequences. The most direct outcome is a reduction in the death benefit paid to beneficiaries. Any unpaid loan amount, along with all accrued interest, is subtracted from the policy’s death benefit when the insured individual dies. This means the beneficiaries will receive a smaller payout than the policy’s stated face amount.

A more severe consequence of an unpaid loan is the potential for the policy to lapse. If the outstanding loan balance, including accumulated interest, grows to exceed the policy’s cash value, the policy can terminate. Insurance companies typically provide notifications to the policyholder in advance of a potential lapse, offering an opportunity to repay a portion of the loan or pay additional premiums to maintain the policy in force. Failure to address the growing loan balance can result in the loss of coverage.

If a policy lapses or is surrendered with an outstanding loan, a taxable event can occur. The amount of the loan that exceeds the policyholder’s “cost basis” – generally the total premiums paid into the policy, less any prior withdrawals – may be considered taxable income by the Internal Revenue Service (IRS). This means the policyholder could owe income taxes on the portion of the loan that represents gains within the policy, rather than a return of their own premiums. This tax implication can be a significant financial burden, particularly for large loans.

While a loan is outstanding, the portion of the cash value used as collateral for the loan typically ceases to earn interest or dividends for the policyholder. However, any remaining cash value in the policy that is not encumbered by the loan usually continues to grow according to the policy’s terms. This distinction is important, as it means the policy’s overall cash value growth may be slowed, but not entirely halted, by the presence of a loan.