How to Borrow Against Your Life Insurance

Life insurance policies can offer more than just a death benefit; certain types also accumulate cash value, which policyholders may access during their lifetime. This cash value grows over time on a tax-deferred basis, creating a financial resource that can be borrowed against. Understanding how to utilize this feature involves knowing which policies qualify, the mechanics of such a loan, the procedural steps to obtain funds, and the potential financial ramifications of borrowing.

Understanding Policy Eligibility and Loan Mechanics

Only life insurance policies with a cash value component allow for borrowing against their accumulated value. These typically include whole life, universal life, and variable universal life insurance policies, which are designed to build cash value over the policy’s lifetime. Term life insurance, by contrast, is purely coverage for a specific period and does not accumulate any cash value, meaning it cannot be used for policy loans.

The amount available for a policy loan is generally determined by the policy’s accumulated cash surrender value, which is the amount you would receive if you canceled the policy. Insurers typically allow policyholders to borrow up to a certain percentage of this cash value, often around 90% or more, depending on the specific policy terms and the insurer’s guidelines. This loan is not a withdrawal from your cash value; instead, it is a loan from the insurer, with your policy’s cash value serving as collateral.

When you take a policy loan, the cash value remains intact within the policy, continuing to earn interest or dividends as specified by your policy, though the portion encumbered by the loan may earn at a different rate or not participate in dividends. Interest rates on policy loans are set by the insurer and can be either fixed or variable, typically ranging from 4% to 8% annually. This interest accrues on the outstanding loan balance, similar to other types of loans.

Repayment of the principal and accrued interest is generally not mandatory during the policyholder’s lifetime. However, interest will continue to accrue on the outstanding balance, increasing the total amount owed. The loan remains outstanding against the policy until it is repaid, the policy matures, or the insured passes away.

The Borrowing Process

Initiating a policy loan typically involves a straightforward process, though the exact steps can vary slightly depending on the insurance company. The first step usually requires contacting your insurer directly to express your intent to borrow against your policy. Many insurers offer multiple channels for this, including phone, mail, or through secure online policyholder portals.

Upon contact, the insurer will provide a specific loan request form that needs to be completed. This form will ask for your policy number, the desired loan amount, and your signature to authorize the transaction.

Once the completed loan request form is submitted, the insurer will process the application. Processing time can range from a few business days to a couple of weeks, depending on the insurer’s procedures and submission method.

After approval, funds are disbursed according to your preference indicated on the form. Common methods include a check mailed to your address or a direct deposit into your designated bank account. Confirm the expected disbursement method and timeline with your insurer during the application process.

Repaying the Loan and Its Financial Impact

Repaying a life insurance policy loan offers flexibility; policyholders can choose to repay the principal and interest in scheduled installments, make interest-only payments, or allow interest to accrue without making payments. Any outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries. For example, if a policy has a $500,000 death benefit and an outstanding loan of $50,000, beneficiaries would receive $450,000 upon the insured’s passing.

A significant consequence of not repaying the loan is the potential for the policy to lapse. If the outstanding loan amount, combined with accrued interest, grows to exceed the policy’s cash value, the policy can terminate, especially if premium payments are also not maintained. This scenario is particularly risky because if a policy lapses with an outstanding loan, the loan amount that exceeds the premiums paid can become taxable income to the policyholder. For instance, if you paid $30,000 in premiums and took a $40,000 loan, and the policy lapses, the $10,000 difference could be considered taxable gain.

Furthermore, an outstanding policy loan can affect the policy’s cash value growth. While the cash value typically continues to earn interest or dividends, the portion of the cash value that secures the loan may not participate in dividend payments or may earn at a reduced rate. This can slow the overall growth of your policy’s cash value, potentially impacting its long-term financial performance and reducing the amount available for future loans or withdrawals.

Regularly review your policy’s specific terms and conditions regarding loans, as these details can vary significantly between policies and insurers. Consulting with a financial advisor or your insurance provider can provide personalized guidance regarding your policy’s unique features, repayment options, and the potential financial and tax implications of taking a loan.