Can You Borrow Off Your Life Insurance?

A life insurance policy can serve as a financial resource during the policyholder’s lifetime. One way to access this financial value is through a life insurance loan. This allows individuals to borrow funds directly from their policy, using its accumulated value as collateral. Such a loan is distinct from traditional lending, as it does not involve a bank or a typical credit assessment process.

Understanding Life Insurance Loans and Eligibility

The ability to borrow against a life insurance policy hinges on the presence of cash value, a savings component that accumulates within certain types of policies. This cash value grows over time, typically on a tax-deferred basis, and represents a portion of the premiums paid into the policy.

Term life insurance policies do not build cash value and therefore do not offer the option to borrow funds. These policies provide coverage for a specific period and focus on the death benefit. In contrast, permanent life insurance policies accumulate cash value, making them eligible for loans.

Policies such as whole life insurance and universal life insurance are examples of permanent life insurance. Whole life policies typically feature guaranteed cash value growth, while universal life policies offer more flexibility in premium payments and cash value accumulation, with growth often tied to interest rates or market indices. A policy loan is a debt that must be repaid, whereas a withdrawal permanently reduces the policy’s cash value and can diminish the death benefit.

How to Access a Life Insurance Loan

Accessing a life insurance loan begins with determining the available loan amount, typically a percentage of the policy’s accumulated cash value. Insurers commonly permit borrowing up to 90% or 95% of the cash value, though this can vary by company and policy terms. Policyholders can find this information by reviewing policy statements or contacting their insurance provider.

The application process for a life insurance loan is straightforward. It involves submitting a loan request form to the insurance company, along with necessary policy details. Since the policyholder is borrowing against their own asset, these loans do not require credit checks or external underwriting.

Once approved, loan funds are disbursed directly to the policyholder, often via direct deposit or check. Interest begins to accrue on the borrowed amount from the date of disbursal. These interest rates, which can be fixed or variable, are set by the insurer and are usually lower than those for unsecured personal loans, often ranging from 5% to 8%.

Managing Your Life Insurance Loan

Managing a life insurance loan involves understanding its flexible repayment terms and potential consequences. Unlike traditional loans, policy loans often have no fixed repayment schedule or strict deadlines. Policyholders can repay at their own pace or choose not to repay the principal. However, interest continues to accrue on the outstanding balance, and if not paid, it is added to the loan amount.

Any outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries. For example, if a policyholder passes away with an unpaid loan of $20,000, that amount will be subtracted from the total death benefit.

An unmanaged policy loan carries the risk of policy lapse. If the outstanding loan balance, including accrued interest, grows to exceed the policy’s cash value, the policy can terminate, leading to loss of coverage.

Tax implications: life insurance policy loans are generally not considered taxable income as long as the policy remains in force. The IRS views these loans as advances against the policy’s cash value. However, if the policy lapses or is surrendered with an outstanding loan, the amount of the loan that exceeds the premiums paid (known as the cost basis) can become taxable income. This occurs because the loan is no longer collateralized by an active policy, and untaxed gains within the policy are then realized.

Modified Endowment Contracts (MECs) present a distinct consideration. A policy becomes an MEC if premiums paid exceed certain IRS limits, specifically failing the “7-pay test” in the first seven years. Loans from MECs are treated differently for tax purposes; they are considered distributions that come from taxable gains first, before non-taxable contributions. This “last-in, first-out” (LIFO) rule means a loan from an MEC can result in taxable income. If the policyholder is under age 59½, an additional 10% penalty tax may apply to the taxable portion.