Can You Borrow Money From Your Life Insurance?
Understand life insurance policy loans: how they function, their key characteristics, and important policy considerations.
A life insurance loan provides a way to access funds from a policy’s accumulated value. Policyholders borrow money from the insurance company, using the policy’s cash value as collateral. This is a loan against the policy, not a withdrawal of the cash value itself.
Policies That Allow Borrowing
The ability to borrow against a life insurance policy is exclusively available with permanent life insurance policies that accumulate cash value. Whole life insurance is a type of permanent policy where a portion of each premium payment is allocated to a cash value component. This cash value grows at a guaranteed fixed interest rate over the policy’s lifetime, providing predictable accumulation.
Universal life insurance, another form of permanent coverage, also builds cash value, but its growth rate can be more dynamic. While universal life policies often offer a guaranteed minimum interest rate, the actual growth may vary based on market conditions or the insurer’s performance. Policyholders may have flexibility in premium payments with universal life, which can influence cash value accumulation.
Cash value accumulation is a prerequisite for taking a policy loan, which is why term life insurance policies do not offer this option. Term life insurance provides coverage for a specific period and focuses solely on the death benefit without building any cash value.
Key Aspects of Life Insurance Loans
A life insurance loan functions as an advance from the insurer, with the policy’s cash value serving as collateral. The funds for the loan do not directly come from the policy’s cash value, meaning the cash value continues to grow and earn interest or dividends even while the loan is outstanding. This allows the policy’s internal values to compound without interruption.
Interest rates for life insurance loans are typically set by the insurance company and can be either fixed or variable, often ranging between 5% and 8%. Interest accrues on the outstanding loan balance, and if not paid, it can be added to the loan principal, increasing the total amount owed. This compounding interest can significantly impact the loan balance over time.
One notable characteristic of life insurance loans is the absence of traditional lending requirements. There are generally no credit checks, income verification, or lengthy application processes, as the loan is secured by the policy’s own cash value.
Policy loans are generally not considered taxable income as long as the policy remains in force and the loan amount does not exceed the total premiums paid. The Internal Revenue Service (IRS) views these funds as a debt rather than income. There is no set repayment schedule for life insurance loans, offering policyholders significant flexibility in how and when they choose to repay the borrowed amount.
Accessing Funds and Policy Consequences
Policyholders usually contact their insurance company directly, either by phone, through an online portal, or by mail. They will need to complete a loan request form, which confirms the desired loan amount and acknowledges the terms. Once the request is submitted and eligibility is confirmed, funds are generally disbursed within a matter of days, though it can sometimes take a few weeks.
An outstanding life insurance loan has direct implications for the policy and its beneficiaries. Policyholders have flexible repayment options, including making regular payments of principal and interest, paying only the interest, or not making any payments at all. Payments are typically applied first to accrued interest before reducing the principal balance.
An outstanding loan impacts the death benefit. If the policyholder passes away with an unpaid loan balance, including any accrued interest, that amount will be deducted directly from the death benefit paid to the beneficiaries. This reduces the financial protection intended for loved ones. For example, a $250,000 death benefit with a $50,000 outstanding loan would result in beneficiaries receiving $200,000.
There is also a risk of policy lapse if the loan balance, along with accrued interest, grows to exceed the policy’s cash value. Should a policy lapse under these circumstances, the unpaid loan amount, to the extent it exceeds the policy’s cost basis (premiums paid minus any tax-free distributions), may become taxable income to the policyholder. This can result in an unexpected tax liability. Additionally, an outstanding loan reduces the policy’s surrender value, which is the amount received if the policy is terminated.