Can You Borrow Money From Life Insurance?

Can You Borrow Money From Life Insurance?

Certain types of life insurance policies offer a unique method for accessing liquidity through a policy loan. This mechanism allows policyholders to borrow money directly from their insurance company, using the accumulated value within their policy as collateral. Unlike conventional loans, these funds are not subject to typical credit checks or lengthy application processes.

Repayment terms are often more lenient than those of standard loans. Policy loans are distinct from withdrawals, which permanently reduce the policy’s cash value and death benefit. Understanding the nuances of these loans, including which policies qualify and their mechanics and consequences, is important for anyone considering this option.

Qualifying Life Insurance Policies

The ability to borrow from a life insurance policy hinges on the presence and accumulation of “cash value” within the policy. Cash value is a savings component that grows over time, separate from the policy’s death benefit. A portion of each premium payment contributes to this cash value, which also earns interest or investment returns, allowing it to grow on a tax-deferred basis.

Policies that build cash value and therefore permit loans include whole life, universal life, and variable universal life insurance. Whole life policies offer guaranteed cash value growth at a fixed rate, providing predictable accumulation. Universal life policies provide more flexibility in premium payments and death benefits, with cash value growth often tied to an interest rate set by the insurer. Variable universal life policies link cash value growth to investment performance in various sub-accounts, offering potential for higher returns but also carrying investment risk.

In contrast, term life insurance policies do not accumulate cash value. These policies provide coverage for a specific period, typically 10, 20, or 30 years, and only pay out a death benefit if the insured passes away within that term. Term life insurance policies do not offer the option to borrow against them. The capacity to obtain a loan is directly dependent on the policy’s cash value reaching a sufficient level, which generally takes several years of premium payments.

Understanding the Loan Mechanics

When a policyholder takes a loan against their life insurance, they are not directly withdrawing money from the cash value itself. Instead, the insurance company lends the policyholder funds, using the policy’s cash value as collateral. The loan amount is typically limited to a percentage of the policy’s accumulated cash value, often ranging from 75% to 90% of the cash surrender value.

Interest accrues on the outstanding loan balance, similar to any other loan. The interest rates for policy loans can be either fixed, such as a set 5% to 8%, or variable, often tied to an external index like Moody’s Corporate Bond Yield Average. Some policies may also feature adjustable rates that can change periodically.

There is typically no rigid repayment schedule for a life insurance policy loan, providing significant flexibility. However, interest continues to compound as long as the loan remains outstanding. While no credit checks or income verifications are required, the policy’s cash value acts as the sole security for the loan. If the loan balance, including accrued interest, were to exceed the cash value, the policy could be at risk of lapsing.

Repayment and Policy Consequences

The repayment of a life insurance policy loan offers considerable flexibility, distinguishing it from most other forms of debt. Policyholders can choose to repay the loan at their own pace, make interest-only payments, or allow the interest to accrue and be added to the outstanding principal balance. There are no strict monthly payment requirements or deadlines, providing a unique level of control over the repayment process.

However, allowing the loan balance and accrued interest to remain outstanding carries consequences for the policy and its beneficiaries. Any unpaid loan balance, along with accumulated interest, will directly reduce the death benefit paid out to beneficiaries upon the insured’s passing. For instance, if a policy has a $500,000 death benefit and an outstanding loan of $50,000, beneficiaries would receive $450,000.

A more severe consequence arises if the loan balance, plus accrued interest, grows to exceed the policy’s cash value. In such an event, the policy may lapse, meaning the coverage terminates. If a policy lapses with an outstanding loan, the loan amount, to the extent it exceeds the total premiums paid into the policy, can be treated as taxable income by the Internal Revenue Service (IRS). This unexpected tax liability can be substantial. Even if the policy does not lapse, the outstanding loan reduces the net cash value available for future withdrawals, surrenders, or collateral for additional loans.