Do You Have to Pay Back a Life Insurance Loan?

Life insurance loans allow policyholders to access funds from a permanent life insurance policy’s accumulated cash value. This financial tool differs from conventional borrowing methods, providing distinct considerations for those seeking liquidity.

Understanding Life Insurance Loans

A life insurance loan differs from a traditional loan obtained from a bank or credit union. Instead of borrowing from a third-party lender, you are essentially borrowing your own money, with the policy’s cash value serving as collateral. This means there are typically no credit checks or lengthy approval processes involved.

These loans are generally available on permanent life insurance policies, such as whole life or universal life insurance, which build a cash value component over time. Term life insurance policies, conversely, do not accumulate cash value and therefore do not offer a loan option. Interest accrues on these loans, with rates typically ranging from 5% to 8% per annum, though they can be fixed or variable depending on the policy. The loan amount, usually up to 90% of the cash value, reduces the policy’s cash value and the death benefit while the loan remains outstanding.

The Repayment Question

Life insurance loans generally have no strict repayment schedule or legal obligation to repay, provided the policy remains active. Policyholders have the flexibility to repay the loan at their convenience, or not at all. If the loan is not repaid, the outstanding loan balance, along with any accrued interest, will be subtracted from the death benefit paid to beneficiaries.

A significant risk arises if the outstanding loan balance, including accumulated interest, grows to exceed the policy’s cash value. The insurance company may then terminate the policy. This event, known as a policy lapse, results in the loss of life insurance coverage.

Impact of an Outstanding Loan

An outstanding life insurance loan impacts the policy’s financial components. It reduces the net death benefit payable to beneficiaries. For instance, if a policy has a $250,000 death benefit and an outstanding loan of $50,000 (including interest), the beneficiaries would only receive $200,000. This reduction ensures that the insurance company recoups the loan amount from the policy’s proceeds.

An unpaid loan can also erode the policy’s cash value. The continued accrual of interest on the loan, if not paid, adds to the principal loan balance, which can diminish the cash value available for future withdrawals or additional loans. If the growing loan balance eventually surpasses the cash value, it can trigger a policy lapse, eliminating the death benefit entirely. Interest on these loans compounds, meaning interest is charged not only on the original loan amount but also on any unpaid accumulated interest.

Managing Your Loan

Policyholders can manage a life insurance loan in several ways. They can make regular payments of both principal and interest, similar to a standard loan, or they can make partial lump-sum payments when funds are available. Alternatively, the loan can remain outstanding, with the balance deducted from the death benefit upon payout.

Managing these loans involves potential tax implications, particularly if the policy lapses, as the Internal Revenue Service (IRS) may consider the portion of the loan that exceeds the policy’s “cost basis” as taxable income if a policy terminates with an outstanding loan. The cost basis generally represents the cumulative amount of premiums paid into the policy by the policyholder. For example, if premiums paid totaled $80,000 and the cash value was $150,000 when a $100,000 loan was taken and the policy lapsed, $70,000 ($150,000 cash value minus $80,000 premiums paid) could be considered taxable income. This taxable event, often reported on Form 1099-R, can result in an unexpected tax liability. It is important to consult with your insurance provider or a qualified financial advisor to understand the specific terms of your policy and the most suitable approach for your financial situation.