Can You Take a Loan From Your Life Insurance?

Certain life insurance policies allow policyholders to access funds by taking a loan against their accumulated cash value. This option enables them to leverage their policy’s value for various financial needs. Not all policies offer this feature; only those with a savings component can serve as a source of accessible funds.

Qualifying Life Insurance Policies

Life insurance policies that build cash value allow policyholders to take out loans. These are permanent life insurance policies, which contrast with term life insurance. Term life policies provide coverage for a specific period and do not accumulate cash value.

Whole life insurance is a type of permanent policy where cash value grows at a guaranteed rate over time. This accumulation is predictable and unaffected by market fluctuations. Universal life insurance policies also build cash value, which grows based on interest rates set by the insurer or linked to market performance. These policies offer flexibility in premium payments, influencing cash value accumulation.

Variable universal life insurance allows policyholders to invest the cash value in various sub-accounts, similar to mutual funds. The cash value growth in these policies is tied to the performance of the chosen investments, offering potential for higher returns but also carrying investment risk. Regardless of the specific type of permanent policy, the accumulated cash value serves as the collateral for any policy loan.

Understanding the Loan Process

Initiating a loan from a life insurance policy involves contacting the insurer and submitting a request, which does not require a credit check or a formal approval process. The maximum amount a policyholder can borrow is usually a percentage of the policy’s cash surrender value, commonly ranging from 90% to 95%. It may take several years for a policy to build sufficient cash value to support a meaningful loan.

Interest is charged on the loan. This interest rate can be fixed or variable, often tied to a market index, and is generally lower than rates for personal loans or credit cards. The loan is secured by the policy’s cash value. Policy loan repayment offers significant flexibility; there is no fixed repayment schedule, and policyholders can make payments at their discretion, or even choose not to repay the loan during their lifetime.

The portion of the cash value used as collateral for the loan may continue to earn interest, but often at a different, potentially lower, rate than the unencumbered cash value. This can impact the policy’s overall cash value growth. If left unpaid, the loan balance, including accrued interest, will be deducted from the death benefit when the policyholder passes away.

Tax Considerations for Life Insurance Loans

Policy loans are not considered taxable income as long as the life insurance policy remains in force. This tax-free treatment allows access to funds without immediate tax implications. However, an exception arises if the policy lapses or is surrendered with an outstanding loan. In such cases, the loan amount, up to the policy’s gain (the amount exceeding the premiums paid), may become taxable income.

The “basis” of a life insurance policy refers to the cumulative amount of premiums paid into the policy by the policyholder. When a policy is surrendered or lapses, only the portion of the cash value that exceeds this basis is subject to taxation. Modified Endowment Contracts (MECs) are treated differently under tax law. If a policy becomes an MEC due to overfunding, loans taken from it may be taxable and subject to a 10% penalty if the policyholder is under age 59½. Understanding a policy’s MEC status is important before taking a loan.

Consequences for Your Policy and Beneficiaries

An outstanding policy loan impacts the life insurance policy and its beneficiaries. Any unpaid loan amount, along with accrued interest, will be subtracted from the death benefit paid to beneficiaries upon the policyholder’s death. This reduces the financial support beneficiaries receive.

An unpaid loan can also increase the risk of the policy lapsing. If the accumulating loan balance and interest erode the policy’s cash value to a point where it can no longer cover policy charges, the insurer may terminate the coverage. A policy lapse with an outstanding loan can trigger adverse tax consequences, as the loan amount may then be considered taxable income. The portion of cash value used as collateral for the loan may not continue to grow at the same rate as the unencumbered cash value, which can slow the overall accumulation within the policy.