Can You Borrow Money From Your Life Insurance?

Eligible Life Insurance Policies

Borrowing money directly from a life insurance policy is possible, but this capability is not universal across all policy types. This is exclusively available with life insurance policies that accumulate a cash value component. Unlike traditional loans obtained from banks or other lending institutions, a policy loan leverages the policy’s own accumulated value rather than a third-party lender.

Only permanent life insurance policies are eligible for policy loans because they include a cash value component that grows over time. Whole life insurance, for instance, is one such type, providing a guaranteed cash value growth rate and a level premium for the life of the policy. Universal life insurance also builds cash value, offering more flexibility in premium payments and death benefits compared to whole life policies. Variable universal life insurance, another permanent option, allows policyholders to invest the cash value in various sub-accounts, which can lead to higher growth potential but also involves investment risk.

Term life insurance policies do not offer a cash value component and therefore do not allow policy loans. These policies are designed to provide coverage for a specific period, such as 10, 20, or 30 years, and typically only pay a death benefit if the insured passes away within that term.

How Policy Loans Work

A life insurance policy loan functions as an advance against the policy’s cash value, rather than a traditional loan from the insurer’s general assets. When a policyholder takes a loan, the insurer provides access to the policy’s accumulated cash value, with the policy itself acting as collateral. The cash value within the policy continues to accumulate, but interest is charged on the outstanding loan balance.

Interest rates on policy loans can be either fixed or variable, ranging from 5% to 9% annually, though rates can fluctuate based on market conditions and the specific insurer. For example, a fixed rate might be set at 6% for the life of the loan, while a variable rate could be tied to an external index, adjusting periodically. The interest accrues on the loan balance, increasing the total amount owed over time. This interest must be paid to prevent the loan balance from growing excessively and potentially impacting the policy.

One distinct feature of a policy loan is the absence of a credit check, as the loan is collateralized by the policy’s cash value. There is also no fixed repayment schedule, offering policyholders significant flexibility. While there is no legal obligation to repay the loan during the insured’s lifetime, the outstanding balance and accrued interest will reduce the death benefit paid to beneficiaries. This means the policyholder can choose to repay the loan fully, partially, or not at all, understanding the implications for the future death benefit.

Impact on Your Coverage

Taking a life insurance policy loan has direct consequences for your coverage, particularly if the loan remains unpaid or accrues substantial interest. The most immediate effect is a reduction in the death benefit payable to your beneficiaries. The outstanding loan balance, including any accrued and unpaid interest, is subtracted from the face amount of the policy when the death benefit is paid out. For example, a $500,000 policy with a $50,000 outstanding loan would result in a $450,000 payout to beneficiaries.

A significant risk associated with policy loans is the potential for policy lapse, especially if the loan balance, including accrued interest, grows to exceed the policy’s cash value. Insurers provide a grace period to repay a portion of the loan or add funds to the cash value to prevent lapse. Failure to address the deficit within this timeframe can lead to the policy’s cancellation.

If a policy lapses with an outstanding loan, there can be significant tax implications. The amount of the loan that exceeds the premiums paid into the policy can be considered taxable income by the Internal Revenue Service (IRS). This potential tax liability can be a substantial and unexpected financial burden for the policyholder.

Managing and Repaying Your Loan

Managing a life insurance policy loan offers flexibility, as policyholders are not bound by a strict repayment schedule. You can repay the loan in full, make partial payments, or choose not to repay it at all during your lifetime. Making regular payments helps to reduce the outstanding balance and minimize interest accrual. This approach ensures the loan does not significantly erode your policy’s value or impact its long-term stability.

It is important to continuously monitor the loan balance to prevent it from growing to a point where it negatively affects your policy. Interest accrues on the outstanding loan amount, and if this interest is not paid, it is added to the principal balance, leading to compounding interest. This can accelerate the growth of the loan, potentially increasing the risk of policy lapse if the loan balance approaches or exceeds the cash value. Regular reviews of your policy statements can help you track the loan’s progress.

Repaying your policy loan, whether through a lump sum or periodic payments, directly restores your policy’s cash value and the full death benefit. Each payment reduces the outstanding balance, allowing more of the cash value to grow unencumbered. This also ensures that your beneficiaries will receive the full intended death benefit upon your passing, without any deductions for an outstanding loan. The flexibility of repayment allows you to manage the loan according to your financial situation while preserving the integrity of your life insurance coverage.