Can You Take Out a Loan From Your Life Insurance?

Life insurance policies can serve a purpose beyond providing a death benefit to beneficiaries. Certain types of policies are designed to accumulate cash value, which policyholders may be able to access during their lifetime. This accumulated cash value can be a source of funds, and one way to tap into it is by taking a loan directly from the policy.

Policies That Allow Loans

Taking a loan from a life insurance policy depends on whether it builds cash value. Permanent life insurance policies, unlike term life insurance, include a savings component that accumulates cash over time. The three primary types of permanent life insurance that allow for policy loans are whole life, universal life, and variable universal life.

Whole life insurance policies build cash value at a guaranteed rate, specified when the policy is issued. A portion of each premium payment is allocated to this cash value, which grows on a tax-deferred basis through compound interest. The cash value is a guaranteed amount available to the policyholder.

Universal life insurance policies offer more flexibility, with cash value growth tied to interest rates set by the insurer or linked to market performance, often with a guaranteed minimum rate. Premiums paid into a universal life policy are split, with a portion covering the cost of insurance and administrative fees, and the remainder contributing to the cash value. This design allows for adjustments to premiums and death benefits, influencing how the cash value accumulates over time.

Variable universal life insurance allows policyholders to allocate their cash value among various investment sub-accounts, similar to mutual funds. This offers the potential for higher growth, but also carries investment risk, meaning the cash value can fluctuate with market performance. The cash value in variable universal life policies grows on a tax-deferred basis and can be accessed through loans.

The Loan Process

Obtaining a loan from a life insurance policy is straightforward, as the policy’s cash value serves as collateral. Policyholders contact their insurance provider to initiate the request. This process typically does not require a credit check or formal approval. The only prerequisite is the policy having accumulated sufficient cash value to support the requested loan.

The amount available for a loan is limited to a percentage of the policy’s accumulated cash value, up to 90%. For instance, if a policy has $50,000 in cash value, a policyholder might be able to borrow up to $45,000. The loan is provided by the insurer, using the policy’s cash value as security, rather than a withdrawal of the policyholder’s funds.

Policy loans accrue interest, which can be fixed or variable, depending on policy terms and the insurer. Interest rates range from 5% to 8%, often more competitive than personal loans or credit cards. If interest is not paid, it is added to the outstanding loan balance, causing the loan to grow.

Understanding the Impact

Taking a loan from a life insurance policy offers flexibility, as there is no rigid repayment schedule. Policyholders can repay the loan at their own pace, or pay only the interest, allowing the principal balance to remain outstanding. Interest continues to accrue on the unpaid loan balance, which can impact the policy.

An outstanding loan, including accrued interest, directly reduces the death benefit payable to beneficiaries. If the policyholder passes away with an unpaid loan, the insurer will deduct the outstanding balance from the death benefit. Beneficiaries will receive a smaller payout than the policy’s face value.

A risk with policy loans is the potential for policy lapse. If the accumulated loan balance, including interest, exceeds the policy’s cash value, the policy can terminate. Should a policy lapse with an outstanding loan, the loan amount exceeding the policyholder’s basis (total premiums paid) may become taxable income.

If the policy is classified as a Modified Endowment Contract (MEC), tax implications differ. A policy becomes a MEC if overfunded, meaning premiums paid exceed certain IRS limits within the first seven years. For MECs, loans are treated as distributions of earnings first, taxable as ordinary income to the extent of any gain. If the policyholder is under age 59½, a 10% penalty tax may also apply.