Can You Borrow on Your Life Insurance?

It is possible to borrow against certain types of life insurance policies. This capability is tied to policies that accumulate cash value. Unlike conventional loans from banks or credit unions, borrowing against life insurance involves accessing your own policy’s value. This financial tool can provide liquidity without requiring a traditional loan application process.

Policy Types That Allow Borrowing

The ability to borrow against a life insurance policy hinges on whether the policy accumulates cash value. Cash value represents a portion of the premiums paid that grows over time, separate from the policy’s death benefit. Policyholders can access this accumulated value during their lifetime.

Whole life insurance is a common type of policy that builds cash value. Premiums remain level, and a portion is allocated to the cash value, which grows on a guaranteed basis. This makes whole life policies a reliable source for policy loans.

Universal life insurance also accumulates cash value, but it offers more flexibility in premium payments and death benefits. Policyholders can adjust premiums within certain limits, and the cash value growth may be tied to an interest rate set by the insurer. Its accumulation might vary more than with whole life policies.

Variable universal life insurance introduces an investment component, allowing policyholders to allocate cash value to various sub-accounts, similar to mutual funds. While this type of policy can offer potentially higher cash value growth, it also carries investment risk. Borrowing against the accumulated cash value remains an option.

In contrast, term life insurance does not accumulate cash value. These policies provide coverage for a specific period, and premiums are solely for the death benefit protection. Consequently, policyholders cannot borrow against a term life insurance policy.

Understanding How Policy Loans Work

A policy loan is not money borrowed directly from the insurance company in the traditional sense. Instead, it is an advance against the policy’s accumulated cash value. This means the policyholder is accessing their own funds, which remain within the policy. Since the loan is secured by the policy’s cash value, there is no credit check or extensive application process required. This can make policy loans a convenient option for accessing funds quickly without impacting one’s credit score.

Interest is charged on the outstanding loan balance, and the rates are set by the insurer. These rates can be either fixed or variable, generally ranging from 5% to 8% annually. The interest accrues over time and can compound if not paid regularly.

Policy loans directly impact the policy’s death benefit. Any outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries upon the policyholder’s death. For example, if a policy has a $100,000 death benefit and a $10,000 outstanding loan, beneficiaries would receive $90,000.

Unlike traditional loans that have a mandatory repayment schedule, policy loans offer significant flexibility. Policyholders can repay the loan at their own pace, make sporadic payments, or even choose not to repay it at all. There are no fixed monthly payments required.

However, the amount that can be borrowed is not the full cash value. Insurers limit the loan amount to a percentage of the policy’s cash surrender value, often up to 90%. This ensures that a portion of the cash value remains in the policy to keep it in force and prevent immediate lapse. It may take several years for a policy to build sufficient cash value to support a meaningful loan.

Important Considerations for Borrowers

When considering a policy loan, understanding the implications of interest accrual is important. Interest accumulates on the outstanding loan balance, and if left unpaid, it can compound, increasing the total amount owed. This compounding interest can erode the policy’s cash value over time, even if no additional principal is borrowed.

A risk associated with policy loans is the potential for policy lapse. If the outstanding loan balance, along with accrued interest, grows to exceed the policy’s cash value, the policy can terminate. This means the insurance coverage would cease, and the policyholder would lose the death benefit protection. Policy lapse can have financial consequences, as the original purpose of the insurance is undone.

Should a policy lapse with an outstanding loan, there can be tax implications. The amount of the loan that exceeds the premiums paid into the policy may become taxable income. This is because the IRS treats the amount borrowed as a return of premium up to the cost basis, but any amount beyond that can be considered taxable gain. This unexpected tax liability can be considerable, particularly for older policies with significant cash value growth.

Borrowing against a policy impacts the financial protection intended for beneficiaries. A reduced death benefit means less financial security for those the policy was designed to protect. This can contradict the original objective of obtaining life insurance, which is often to provide for dependents or cover final expenses.

While policy loans offer advantages, consider alternative financial options. Depending on individual circumstances and goals, other avenues such as withdrawals from the policy’s cash value or traditional loans from financial institutions might be more suitable. Each option carries its own set of advantages and disadvantages that warrant careful evaluation.

Managing Your Policy Loan

Managing a policy loan leverages the flexibility it offers. Policyholders retain the freedom to repay the loan at their convenience, whether through regular payments, intermittent contributions, or by allowing the loan balance to remain outstanding. This adaptability allows individuals to align repayments with their financial circumstances without strict deadlines.

Repaying the loan offers advantages by restoring the policy’s cash value and the original death benefit. This ensures the policy’s protective value is maintained, providing the intended financial security for beneficiaries. Timely repayment also prevents the loan from eroding the policy’s value over time, preserving its long-term benefits.

Conversely, not repaying the loan carries long-term consequences. The outstanding balance and accruing interest will continue to reduce the death benefit. Prolonged non-repayment increases the risk of policy lapse if the loan balance eventually exceeds the cash value.

Regularly monitoring your policy’s cash value and loan balance is important. This helps policyholders track the growth of their cash value against the accumulating loan interest, allowing for informed decisions regarding repayment strategies. Staying informed about these figures can prevent unintended policy lapse or reductions in the death benefit.

For personalized guidance, consulting with a financial advisor or directly contacting the insurance company is advisable. These professionals can provide tailored advice, clarify policy-specific terms, and help develop a strategy that aligns with individual financial goals and risk tolerance.