How to Borrow From Your Life Insurance Policy

A life insurance policy loan allows policyholders to access the accumulated cash value within certain types of life insurance policies. The policy itself serves as collateral for the borrowed amount, providing a way to tap into funds without needing a traditional loan from an external lender. These loans offer a flexible financial resource.

Policy Types and Loan Eligibility

Not all life insurance policies offer the ability to borrow against them; only permanent life insurance policies include a cash value component that can be accessed. Whole life and universal life policies are common examples that accumulate cash value over time. Term life insurance, designed solely for a specific period of coverage, does not build cash value and therefore cannot be borrowed against.

Cash value within these policies grows as a portion of each premium payment is allocated to a savings or investment component. In whole life policies, cash value typically grows at a guaranteed interest rate, offering predictability. Universal life policies provide more flexibility, with cash value growth often linked to current interest rates or market performance, though usually with a guaranteed minimum rate.

It usually takes several years for sufficient cash value to build, often around 2 to 5 years for initial accumulation, and potentially 10 years to reach a meaningful amount for borrowing. Insurers typically allow policyholders to borrow up to a certain percentage of the cash value, commonly ranging from 90% to 95%.

Understanding the Loan Terms

A life insurance policy loan is an advance from the insurance company using your policy’s cash value as collateral. This means a credit check is generally not required, nor is income or employment verification.

Interest rates on these loans can be either fixed or variable, typically ranging from 4% to 8%. These rates are often more competitive than those found with personal loans or home equity loans. Interest accrues on the outstanding loan balance, and this interest is added to the loan principal if not paid.

A policy loan is generally not considered a taxable event as long as the policy remains in force. However, if the policy lapses or is surrendered with an outstanding loan, the amount borrowed that exceeds the premiums paid can become taxable income. This applies particularly if the policy is classified as a Modified Endowment Contract (MEC), where loans can be taxed as ordinary income, and a 10% penalty may apply if the policyholder is under age 59½.

The cash value securing the loan may be subject to different interest or dividend crediting rates, a practice known as direct recognition. While the entire cash value continues to exist within the policy, the portion used as collateral for the loan might earn a reduced or different rate of return compared to the unborrowed portion. This can impact the overall growth of your policy’s cash value.

The Application and Disbursement Process

Obtaining a loan from your life insurance policy generally involves a direct process with your insurance provider. The first step is to contact your insurance company or agent to inquire about their specific loan procedures and requirements.

You will typically need to complete a loan request form provided by the insurer. The form will usually ask for the desired loan amount and your preferred method of disbursement, such as direct deposit into a bank account.

Once the completed form is submitted, the insurance company reviews the request. Since the loan does not involve external credit checks, the approval process is generally swift. Funds are typically disbursed within a few business days after the application is processed and approved.

Managing Your Policy Loan

Managing a life insurance policy loan offers considerable flexibility in repayment, as there is typically no fixed repayment schedule. Policyholders can choose to repay the principal and interest at their discretion, pay only the interest, or even make no repayments at all during their lifetime. However, interest continues to accrue on the outstanding balance.

An outstanding loan, including any accrued interest, directly reduces the policy’s death benefit. If the policyholder passes away before the loan is fully repaid, the outstanding balance is subtracted from the death benefit paid to beneficiaries. This means beneficiaries will receive a reduced payout.

The presence of a policy loan can also affect the continued growth of the policy’s cash value. In some cases, the portion of the cash value used as collateral for the loan may no longer earn dividends or interest at the same rate as the unencumbered portion. This direct recognition practice means the overall cash value growth may slow down.

A significant risk in managing a policy loan is the potential for the outstanding loan balance, plus accrued interest, to exceed the policy’s cash value. Should this occur, the policy could lapse, resulting in a loss of coverage. If a policy lapses with an outstanding loan, the policyholder may face unexpected tax consequences, as the outstanding loan amount that exceeds the premiums paid can be considered taxable income by the IRS.