How to Borrow Against a Life Insurance Policy

Life insurance policies can offer more than just a death benefit; certain types allow policyholders to access accumulated funds while still living. This unique feature enables individuals to borrow against the cash value that builds within their policy. Understanding this option can provide financial flexibility, offering a source of funds without needing traditional bank loans.

Policy Eligibility and Cash Value

Only specific types of life insurance policies permit borrowing against their value. Permanent life insurance policies, such as whole life, universal life, variable universal life, and indexed universal life, are designed to accumulate cash value over time. In contrast, term life insurance policies do not build cash value and therefore do not offer a borrowing feature.

The cash value is a portion of premium payments allocated to a separate account. This allocated amount grows on a tax-deferred basis, meaning earnings are not taxed as they accumulate. The growth occurs through interest, investment returns, or a combination, depending on the specific policy type. As the cash value increases, it becomes an accessible resource that can be leveraged.

When a policy loan is taken, the cash value of the policy serves as collateral for the loan. The funds are not directly withdrawn from the cash value but are instead borrowed from the insurance company, with the policy’s cash value securing the loan. Most life insurance policies typically allow borrowing up to a certain percentage of the accumulated cash value, commonly around 90%.

Understanding Loan Terms

A policy loan, while accessible, is not interest-free. Interest accrues on the borrowed amount, and rates typically range between 5% and 8%, though these can be fixed or variable depending on the policy’s terms. This interest is paid to the insurance company, not back into the policyholder’s cash value.

The presence of an outstanding loan directly impacts the policy’s death benefit. If the loan, including any accrued interest, is not fully repaid before the insured’s death, the outstanding balance will be deducted from the death benefit paid to beneficiaries.

A substantial risk arises if the total loan balance, encompassing both principal and accumulated interest, grows to exceed the policy’s available cash value. In such circumstances, the policy may lapse, leading to the termination of coverage.

Policy loans are generally not considered taxable income as long as the policy remains in force. This tax-free status is a notable advantage, as the Internal Revenue Service (IRS) views these funds as a loan against an asset rather than a distribution of income. Furthermore, taking a loan against a life insurance policy does not impact an individual’s credit score, nor is it reported to credit bureaus. However, if a policy lapses with an outstanding loan, the loan amount, particularly any gain realized within the policy, may become taxable income.

The Loan Application Process

Initiating a policy loan begins by contacting the life insurance provider. Policyholders can typically reach out through various channels, including phone, secure online portals, or mail. The insurer will provide the necessary forms or guide the policyholder through an online application process.

The application typically requires basic information such as the policy number, the desired loan amount, and contact details. Since the loan is secured by the policy’s cash value, a credit check or a formal approval process akin to traditional lending is generally not required.

Once the application is submitted and processed, funds are typically disbursed efficiently. Policyholders can often choose to receive the funds via direct deposit into a bank account or through a mailed check. The timeline for receiving funds can vary but is often within a few business days to a week.

Managing and Repaying the Loan

After obtaining a policy loan, policyholders have significant flexibility regarding repayment. There is typically no mandatory repayment schedule, allowing individuals to repay the principal and/or interest at their own pace, or even choose not to repay it at all during their lifetime.

However, interest continues to accrue on the outstanding loan balance. If interest payments are not made, the unpaid interest is added to the principal loan amount, causing the total debt to increase.

Monitoring the loan balance and accumulated interest is important to prevent the loan from exceeding the policy’s cash value, which could lead to a policy lapse. While not universally offered, some policies may allow the use of policy dividends to offset accrued interest.