Can You Borrow Money on Your Life Insurance?

Life insurance primarily provides a financial safety net for beneficiaries after the policyholder’s passing. Certain life insurance policies offer cash value, a savings component that accumulates over time and may become accessible to the policyholder during their lifetime. This accumulated value can serve various purposes, including providing a source of funds for unexpected needs or financial planning.

Policies with Cash Value Access

Cash value is the portion of a permanent life insurance policy that accumulates monetary value over time, separate from the death benefit. This component grows on a tax-deferred basis, meaning earnings are not taxed until withdrawn or the policy is surrendered. As premiums are paid, a portion goes towards the cost of insurance and administrative fees, with the remainder allocated to this cash value account to grow through interest or investment gains.

Different types of permanent life insurance policies accumulate cash value in distinct ways. Whole life insurance offers a guaranteed death benefit and fixed premiums that remain level throughout the policy’s life. The cash value in whole life policies grows at a guaranteed interest rate, providing a predictable accumulation.

Universal life (UL) insurance provides more flexibility compared to whole life. Policyholders can adjust premium payments and the death benefit within certain limits. The cash value in universal life policies typically grows based on an interest rate set by the insurer, often with a guaranteed minimum rate, though it can be more sensitive to market conditions than whole life.

Variable universal life (VUL) insurance offers greater control and potential for cash value growth, but with increased risk. In a VUL policy, the cash value can be invested in various sub-accounts, similar to mutual funds. The growth of the cash value is directly tied to the performance of these underlying investments, meaning it can experience substantial gains or losses depending on market fluctuations.

Not all life insurance policies build cash value. Term life insurance provides coverage for a specific period, such as 10, 20, or 30 years, and does not include a cash value component. Policyholders pay premiums solely for the death benefit protection during the chosen term.

How Life Insurance Loans Function

A loan against a life insurance policy’s cash value operates differently from a traditional loan obtained from a bank. Instead of borrowing from a third party, the policyholder borrows money from the insurance company, with the policy’s accumulated cash value serving as collateral.

Interest accrues on the outstanding loan balance, and the insurance company charges a competitive interest rate. Repayment of the loan principal is often flexible, but interest continues to accumulate. Policyholders can choose to repay the loan at their convenience, or not at all, but the outstanding balance and any accrued interest will reduce the death benefit paid to beneficiaries.

The amount a policyholder can borrow is limited by the available cash value within the policy, typically not exceeding a certain percentage. Even with an outstanding loan, the policy’s cash value continues to grow through earned interest or dividends. However, the loan itself also accrues interest, which can diminish the net growth of the cash value over time.

For example, if the cash value earns 4% interest, but the policy loan charges 5% interest, the net effect can be a reduction in the policy’s overall value. This can lead to a slower accumulation of cash value or even a decrease if the loan interest outpaces the policy’s growth.

Loan Effects on Policy and Taxation

Taking a loan against a life insurance policy’s cash value carries direct implications for the policy’s future and its beneficiaries. If a policyholder passes away with an outstanding loan, the unpaid loan balance and any accrued interest are subtracted from the death benefit paid to the beneficiaries.

There is also a risk of policy lapse if the loan balance and accumulated interest grow too large. If the outstanding loan amount, combined with its interest, exceeds the policy’s cash value, the policy can lapse, terminating coverage. This can occur if premiums are not consistently paid or if cash value growth is insufficient to offset the increasing loan balance.

Policy loans are generally treated as tax-free distributions, provided the policy remains in force. However, exceptions exist for policies classified as Modified Endowment Contracts (MEC). A life insurance policy becomes a MEC if it receives more premium payments than allowed under federal tax law, usually within its first seven years.

For MECs, policy loans are treated as taxable distributions to the extent of any gain in the policy’s cash value. Withdrawals or loans from a MEC may also be subject to a 10% penalty tax if the policyholder is under age 59½.

If a policy with an outstanding loan lapses or is surrendered, the loan amount, up to the policy’s gain, can become taxable income in the year of lapse or surrender. This is because the loan is then considered a distribution of the policy’s accumulated tax-deferred earnings.