Financial Planning and Analysis

Can You Get a Loan on Your Life Insurance?

Unlock the potential of your life insurance policy. Understand how to borrow against its value, the process involved, and its financial implications.

You can obtain a loan using your life insurance policy. This option is available through specific types of life insurance that accumulate a cash value over time.

Qualifying Life Insurance Policies

Life insurance policies that allow for loans are those that build cash value. This cash value is a savings component that grows over the life of the policy. Permanent life insurance policies, such as whole life, universal life, variable universal life, and indexed universal life, accumulate cash value. A portion of each premium payment contributes to this cash value, which can grow on a tax-deferred basis.

Term life insurance, in contrast, does not include a cash value component and does not allow for policy loans. Term policies provide coverage for a specific period, offering a death benefit without a savings feature. The ability to borrow against a policy is directly tied to the accumulation of sufficient cash value, which usually takes several years from the policy’s inception.

The cash value serves as the source from which the loan is drawn, and the policy itself acts as collateral. This means the loan is not directly against the death benefit, but rather against the accumulated savings within the policy. The amount available for a loan is generally a percentage of the policy’s cash value, often up to 90%.

How a Life Insurance Loan Operates

A loan against a life insurance policy operates differently from a traditional bank loan. It is essentially an advance from the policy’s cash value, with the policy serving as collateral. Policyholders do not need to undergo a credit check, employment verification, or income requirements, making the process straightforward and often quicker than securing conventional loans.

Interest rates for life insurance loans can be fixed or variable, ranging from 5% to 8%. This interest accrues on the outstanding loan balance. While there is no strict repayment schedule, interest continues to compound if not paid. Policyholders have flexibility in repayment, choosing to pay back the loan over time, in a lump sum, or even only paying the interest.

The borrowed funds do not typically reduce the cash value directly; rather, the cash value continues to grow, potentially offsetting some borrowing costs. However, the loan balance, including accrued interest, reduces the amount of the death benefit paid to beneficiaries if the loan is not repaid before the policyholder’s death. The loan is not reported to credit bureaus.

Understanding Loan Consequences

The most direct consequence of taking a loan against a life insurance policy is a reduction in the policy’s death benefit. Any outstanding loan balance, along with accrued interest, will be subtracted from the death benefit paid to beneficiaries. This can result in beneficiaries receiving a significantly smaller payout than originally intended.

A risk arises if the loan balance, including interest, grows to exceed the policy’s cash value. Should this occur, the policy may lapse, meaning coverage terminates. A policy lapse due to an outstanding loan can trigger a taxable event for the policyholder. Under Internal Revenue Code Section 72, if a policy lapses or is surrendered with an outstanding loan, the amount of the loan that exceeds the total premiums paid into the policy (the cost basis) can be considered taxable income.

While there is no mandatory repayment schedule for life insurance loans, neglecting repayment can lead to this “phantom income” tax liability if the policy lapses. For example, if premiums paid total $24,000 and a loan balance reaches $50,000, the policyholder could owe ordinary income taxes on the $26,000 difference if the policy lapses. Additionally, if the policy is classified as a Modified Endowment Contract (MEC), loans may be taxable as ordinary income, and a 10% penalty could apply if the policyholder is under age 59½.

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