Can You Borrow on Your Life Insurance Policy?
Explore if your life insurance policy can provide accessible funds. Understand the unique way certain policies offer liquidity and how to utilize this financial option.
Explore if your life insurance policy can provide accessible funds. Understand the unique way certain policies offer liquidity and how to utilize this financial option.
Life insurance policies primarily offer financial protection to beneficiaries upon the policyholder’s death. Certain types of life insurance can also serve as a financial resource during the policyholder’s lifetime, allowing access to accumulated funds. This article explores the possibility and mechanics of borrowing against your life insurance policy’s value.
Only specific types of life insurance policies offer the ability to borrow funds. These policies accumulate “cash value,” a savings component that grows over time as premiums are paid. A portion of premiums is allocated to this cash value, which can then be accessed by the policyholder. The growth of this cash value is typically on a tax-deferred basis, meaning you generally do not pay taxes on the growth until you access the funds.
Common examples of policies that build cash value include whole life, universal life, and variable universal life insurance. Whole life policies offer guaranteed cash value growth and a fixed premium, providing predictability. Universal life policies, while offering flexibility in premiums and death benefits, also build cash value that can be borrowed against. In contrast, term life insurance policies do not accumulate cash value and therefore do not allow for policy loans.
It takes time for a policy’s cash value to grow sufficiently to enable borrowing. While some policies may start accruing cash value within two to five years, it might take around 10 years or more for the value to be substantial enough for a meaningful loan. The specific amount of cash value required before a loan can be taken varies by insurer and policy terms.
A policy loan is a distinct financial mechanism compared to traditional loans. When you take a policy loan, you are not borrowing directly from your accumulated cash value. Instead, the insurance company lends you money from its general assets, using your policy’s cash value as collateral. This means the cash value itself remains within the policy, continuing to grow, even while you have an outstanding loan.
The cash value serves as a guarantee for the loan, mitigating risk for the insurer. Because your policy acts as collateral, there is typically no credit check or extensive approval process involved. This can make it a quicker and more accessible source of funds compared to conventional loans.
However, the portion of your cash value used as collateral for the loan may impact its continued growth. Depending on the policy terms, the collateralized amount might earn a reduced interest rate or even stop earning interest or dividends altogether. It is important to distinguish a policy loan from a withdrawal; a loan must be repaid, whereas a withdrawal permanently reduces the policy’s cash value and death benefit.
Policy loans come with specific financial terms and potential implications. Interest is charged on the borrowed amount, similar to any other loan, with rates typically ranging from 5% to 8%. This interest accrues over time, and if not paid, it will be added to the outstanding loan balance.
Policy loans have flexible repayment schedules; there are generally no strict monthly payments required. While this flexibility can be convenient, it means interest continues to accumulate, increasing the total amount owed. Any outstanding loan balance, including accrued interest, will directly reduce the death benefit paid to your beneficiaries.
A significant risk with policy loans is the potential for policy lapse. If the loan balance, including accumulated interest, grows to exceed the policy’s cash value, the policy can lapse. When a policy lapses with an outstanding loan, the unpaid loan amount may be considered taxable income to the extent it exceeds the premiums paid, potentially triggering a tax liability under Internal Revenue Code Section 72. Insurers typically allow borrowing up to a maximum amount, often around 90% of the policy’s cash value.
Initiating a policy loan involves a straightforward process with your insurance provider. The first step is to contact your life insurance company’s customer service or policyholder services department. This contact can often be made through their website, by phone, or via mail.
You will need to request information regarding your policy’s loan eligibility, the current cash value available for a loan, and the applicable interest rates. The insurer can provide an “in-force illustration” that projects how a loan might impact your policy’s future value and death benefit. Once you have this information and decide to proceed, you will typically complete a loan request form. This form may be available online for electronic submission or require a physical signature and mailing.
After the application is submitted, the funds are usually disbursed directly to you through a check or direct deposit. The processing time can vary, but generally, it is quicker than traditional loans, sometimes taking a few weeks. It is important to regularly monitor your loan balance and accrued interest, as the flexible repayment terms mean you must proactively manage the loan to prevent potential negative impacts on your policy.