Can You Take Out a Loan on Your Life Insurance?

Life insurance policies can serve as more than just a death benefit for beneficiaries; certain types can also be a source of funds during the policyholder’s lifetime. This access to funds often comes in the form of a loan, leveraging the accumulated value within the policy. Understanding how these loans operate, which policies qualify, and the implications of taking such a loan is important for policyholders considering this financial option.

Types of Policies Allowing Loans

Life insurance policies vary in how they accumulate value. Only policies that build a cash value component allow policyholders to access funds through a loan feature. This cash value is a savings element that grows over time, separate from the death benefit amount.

Permanent life insurance policies, such as whole life insurance and universal life insurance, are designed to accumulate cash value. Whole life policies offer a guaranteed cash value growth rate, while universal life policies provide more flexibility in premiums and death benefits, with cash value growth often tied to an interest rate or market index. In contrast, term life insurance policies provide coverage for a specific period and do not build cash value, meaning they do not offer a loan feature.

How Life Insurance Loans Function

A life insurance loan is distinct from a traditional bank loan because it is not issued by an external lender. Instead, the loan comes directly from the insurance company, with the policy’s accumulated cash value serving as collateral. Policyholders are not withdrawing their cash value directly; rather, they are borrowing against it. The cash value continues to earn interest or dividends, even while a loan is outstanding.

Obtaining a life insurance loan is straightforward, not requiring a credit check or a formal application. The loan amount is limited to a percentage of the accumulated cash value, up to 90%. Interest accrues on the outstanding loan balance and is paid back to the insurance company. Interest rates for these loans, ranging from 5% to 8%, are determined by the insurer and policy terms. Policyholders have flexibility regarding repayment; there is no mandatory repayment schedule, allowing individuals to repay the loan at any time or choose not to repay it.

Managing Your Life Insurance Loan

Taking out a loan against a life insurance policy carries specific implications. A primary consequence is the impact on the policy’s death benefit. If the loan, along with any accrued interest, is not repaid before the insured’s death, the outstanding balance will be deducted from the death benefit paid to the beneficiaries. This can significantly reduce the amount received by loved ones.

A substantial risk involves the potential for policy lapse. If the loan balance, including accumulating interest, grows to exceed the policy’s cash value, especially if premiums are no longer being paid or the cash value growth is insufficient, the policy could lapse. A policy lapse means the coverage ends, and the policyholder would lose their insurance.

Furthermore, this situation can trigger unfavorable tax consequences. While life insurance loans are generally tax-free as long as the policy remains in force, if the policy lapses or is surrendered with an outstanding loan, the loan amount, up to the policy’s gain (cash value minus premiums paid), can become taxable income. This taxability arises because the loan is no longer considered a loan against an active policy. Policyholders should diligently monitor their loan balance and the policy’s cash value to avoid these unintended outcomes. Understanding the policy’s specific terms regarding loan interest rates, repayment options, and any administrative fees is also important for effective loan management.