Can You Take a Loan Out Against Your Life Insurance?

It is possible to access funds from certain types of life insurance policies without canceling the coverage. These financial arrangements are not considered traditional bank loans from a third-party lender. Instead, they function as advances from the policy’s own accumulated value, with the policy itself serving as collateral for the borrowed amount. This mechanism allows policyholders to tap into their policy’s value without undergoing credit checks, offering a different way to access liquidity.

Policy Eligibility for Loans

Only specific types of life insurance policies allow for loans, primarily those that build a “cash value” component. Cash value represents a portion of the premiums paid that accumulates over time within the policy, functioning as a savings or investment element. This accumulated cash value grows on a tax-deferred basis, meaning earnings are not taxed until they are withdrawn.

Permanent life insurance policies, such as whole life, universal life, variable universal life, and indexed universal life, are designed to build cash value. These policies provide coverage for the policyholder’s entire life, assuming premiums are paid. In contrast, term life insurance policies do not accumulate cash value and therefore do not offer the option to borrow against them.

The amount available for a loan is a percentage of the policy’s accumulated cash value, rather than its full face value. Many insurers allow policyholders to borrow up to 90% of the current cash value. For a loan to be possible, the policy must be “in force,” meaning active and with sufficient cash value established.

Understanding the Loan Process

When a policyholder takes a loan against their life insurance, the funds are provided directly by the insurance company. The money borrowed can be used for any purpose, without restrictions from the insurer.

Interest accrues on the loan, with rates that can be either fixed or variable, as determined by the insurance company. This interest is paid back to the insurer, not to a separate lending institution. A distinctive feature of life insurance loans is the flexible repayment schedule; there is no strict requirement to repay the loan by a specific date. Policyholders can repay the loan at their own pace, or even choose not to repay it at all, though this has consequences. Initiating a loan request is a straightforward process, which involves contacting the insurance provider and submitting a form.

Impact on Policy Value and Beneficiaries

Taking a loan from a life insurance policy has direct implications for both the policy’s value and the benefit paid to beneficiaries. Any outstanding loan balance, along with accrued interest, will reduce the death benefit paid to beneficiaries upon the policyholder’s death. This means the intended financial protection for loved ones could be significantly lessened if the loan is not repaid.

The loan also affects the policy’s cash value. While the loan is “against” the cash value, the portion of the cash value used as collateral for the loan may no longer earn interest or dividends within the policy. This can slow the overall growth of the policy’s cash value over time.

A risk associated with policy loans is the potential for the policy to lapse. If the outstanding loan balance, including accumulated interest, grows to exceed the policy’s remaining cash value, the insurance company may terminate the policy. This can occur if premiums are not paid, or if the loan interest is allowed to capitalize and consume the cash value. A policy lapse means the loss of coverage, and it can also trigger adverse tax consequences for the policyholder.

Tax Considerations and Unpaid Loans

Taking a loan against a life insurance policy is not considered a taxable event. The Internal Revenue Service (IRS) views these funds as an advance against the policy’s own value, rather than a distribution of income. This tax-free treatment holds true as long as the policy remains in force.

Interest paid on a life insurance loan is not tax-deductible for personal policies. Therefore, while the loan itself may not be taxable, the interest payments do not provide a tax benefit.

A tax consideration arises if a policy with an outstanding loan lapses or is surrendered. In such cases, the amount of the loan that exceeds the policyholder’s “basis” (the total premiums paid into the policy) can become taxable income. This can result in a Form 1099-R being issued for “cancellation of indebtedness income,” potentially leading to an unexpected tax bill.

Some policies may be classified as Modified Endowment Contracts (MECs) if they fail the “7-pay test,” which limits the amount of premiums paid in the first seven years. For MECs, loans are treated differently for tax purposes; they are considered taxable distributions to the extent of any gain in the policy. Furthermore, if the policyholder is under age 59½, these taxable distributions from a MEC may also be subject to a 10% penalty.