How to Borrow Against a Life Insurance Policy

Understanding Policy Loans

A life insurance policy loan allows a policyholder to borrow money using the accumulated cash value of their permanent life insurance policy. This provides access to funds without needing to withdraw from the policy, which could reduce its overall value or surrender it entirely. The loan uses the policy’s cash value as collateral, and the insurance company acts as the lender.

Only permanent life insurance policies, such as whole life, universal life, and variable universal life, accumulate cash value over time and are eligible for policy loans. Term life insurance, by contrast, provides coverage for a specific period and does not build cash value, making it ineligible for such loans. The cash value component within a permanent policy grows on a tax-deferred basis, creating a reservoir of funds that can be accessed during the policyholder’s lifetime.

When a policyholder takes out a loan, they are borrowing against their own accumulated cash value, not from the insurer’s general funds. The loan is self-secured, meaning a conventional credit check is typically not required during the application process.

Policy loans accrue interest, similar to other types of loans. This interest is generally paid back to the policy itself, rather than to an external financial institution. The interest rate on these loans is usually fixed or variable, as defined in the policy contract, and is often competitive with or lower than rates for other types of personal loans.

Applying for a Policy Loan

Initiating a life insurance policy loan involves several steps, beginning with gathering information from your policy. Policyholders should locate their policy number, understand the current cash value available, and determine the amount they wish to borrow.

The next step is to obtain the official loan application form from the insurance provider. This can be done by contacting the insurance agent, visiting the insurer’s website for downloadable forms, or calling customer service. Many insurers offer online portals that simplify this process.

The form will generally require details such as the policyholder’s name, policy number, requested loan amount, and preferred method of fund disbursement. Review all sections for accuracy and completeness before submission to avoid delays.

After the form is filled out, it must be submitted to the insurance company through the designated channels. Common submission methods include mailing the physical document, uploading it through a secure online portal, or sending it via fax. Policyholders should confirm the preferred submission method with their insurer.

Upon submission, the insurer will typically process the loan request within a few business days to a week. Funds are usually disbursed via direct deposit or by mailing a check, depending on the policyholder’s preference. A confirmation notice detailing the loan terms, including the outstanding balance and interest rate, is then provided.

Managing and Repaying the Loan

An outstanding policy loan can affect a life insurance policy, particularly concerning the death benefit. If the policyholder passes away before the loan, along with any accrued interest, is fully repaid, the outstanding amount will be deducted from the death benefit paid to the beneficiaries.

The portion of the cash value used as collateral for the loan may also experience a different growth rate compared to the unencumbered cash value. While the loan is outstanding, the collateralized portion might not earn interest or dividends at the same rate it would have otherwise. This can slow the overall accumulation of cash value within the policy.

A risk associated with policy loans is the potential for policy lapse. If the accrued loan interest is not paid, or if the total outstanding loan amount, including principal and interest, eventually exceeds the policy’s cash value, the policy can lapse. A policy lapse means the coverage terminates, which can have adverse tax implications for the policyholder.

Interest accrues on the loan balance, and how it is handled depends on the policy terms. If interest payments are not made, the accrued interest is added to the principal balance of the loan, leading to a larger outstanding amount. This capitalization of interest can cause the loan balance to grow more rapidly over time.

Policy loans offer flexibility in terms of repayment. Unlike traditional bank loans, there are typically no fixed repayment schedules, required monthly payments, or penalties for non-repayment. Policyholders can choose to repay the principal and interest on a flexible schedule, pay only the interest and allow the principal to remain outstanding, or let the interest be added to the loan balance.

Another option is to repay the entire loan balance in a single lump sum. However, allowing the loan to remain outstanding indefinitely will continue to reduce the death benefit and potentially impact the policy’s cash value growth. If a policy with an outstanding loan lapses, any portion of the unpaid loan amount that exceeds the total premiums paid into the policy may be considered taxable income by the Internal Revenue Service (IRS).

This is because the IRS treats the outstanding loan as a distribution from the policy’s cash value. The taxable amount would be the gain realized, which is the cash value minus the total premiums paid. This can create an unexpected tax bill, as the income is taxed at ordinary income rates, not capital gains rates.

Special rules apply if the policy is classified as a Modified Endowment Contract (MEC). If a policy becomes a MEC, loans and withdrawals are taxed on a “Last-In, First-Out” (LIFO) basis, meaning earnings are considered to be withdrawn first and are immediately taxable. If the policyholder is under age 59½, a 10% early withdrawal penalty may apply to the taxable portion of the distribution.