Can You Take a Loan Against Term Life Insurance?

You cannot take a loan against term life insurance. This type of policy does not build cash value, which is the component required for policy loans. Term life insurance serves a different purpose within financial planning compared to policies that allow for borrowing.

Characteristics of Term Life Insurance

Term life insurance provides coverage for a specific period, such as 10, 20, or 30 years. Its primary function is to offer a death benefit to beneficiaries if the insured person passes away within the defined term. Policyholders pay level premiums throughout this period to maintain the coverage.

This type of insurance is chosen for its straightforward nature and affordability, as it focuses solely on providing protection for a temporary need. Unlike some other life insurance products, term life insurance does not include a savings or investment component. As a result, it does not accumulate cash value over time.

The absence of cash value means there is no fund within the policy that can be borrowed against. Insurers do not offer loans for term life policies because there is no internal account from which to draw funds or use as collateral. Once the term expires, the coverage ceases unless it is renewed or converted.

Life Insurance Policies with Cash Value

Certain types of life insurance policies are designed to accumulate cash value over time. These are known as permanent life insurance policies, with common examples including whole life insurance and universal life insurance. A portion of the premiums paid into these policies contributes to this cash value.

Cash value grows on a tax-deferred basis, meaning any earnings are not taxed until they are withdrawn or the policy is surrendered. This accumulated value is distinct from the policy’s death benefit. Policyholders can access this cash value during their lifetime through policy loans or withdrawals.

Whole life policies feature guaranteed cash value growth and fixed premiums. Universal life policies offer more flexibility with premiums and death benefits, and their cash value growth may vary based on market performance or declared interest rates. The cash value component provides a financial resource that can be utilized for various purposes.

Understanding Life Insurance Policy Loans

A loan against a cash value life insurance policy is not a traditional loan from a bank, but rather an advance from the policy’s accumulated cash value. Policyholders can take out a loan as long as there is sufficient cash value. The loan amount cannot exceed the available cash value.

To initiate a policy loan, the policyholder contacts their insurance company and submits a request. The process involves a simple application, as the policy’s cash value serves as collateral. Interest begins to accrue on the loan immediately.

Policy loan interest rates can be fixed or variable, ranging from 3% to 8% or more, depending on the insurer and specific policy terms. Unlike conventional loans, there is no fixed repayment schedule for a policy loan. Repayment is optional, allowing policyholders flexibility.

Repayment is recommended to preserve the policy’s value. Any repayments made first cover accrued interest, with the remainder applied to the principal balance. An outstanding loan balance, including accrued and unpaid interest, will reduce the death benefit paid to beneficiaries upon death.

A policy can lapse if the outstanding loan balance, plus accrued interest, exceeds the policy’s cash value. If a policy terminates with an outstanding loan, the loan amount that exceeds the policy’s basis (the total premiums paid into the policy, less any prior tax-free withdrawals) may become taxable income.