How to Borrow From Your Life Insurance Policy

Borrowing from a life insurance policy offers a way for policyholders to access funds while their coverage remains in effect. This involves leveraging the accumulated cash value within certain types of life insurance, providing liquidity without needing traditional loans. It allows individuals to utilize their policy’s value for various financial needs while maintaining their insurance protection.

Understanding Policy Eligibility and Cash Value

Only permanent life insurance policies, such as whole life, universal life, and variable universal life, accumulate cash value and thus allow for borrowing. Term life insurance policies do not have a cash value component and do not offer a loan option.

The cash value within these permanent policies grows over time, acting as a savings component alongside the death benefit. Cash value builds from premium payments, growing through guaranteed interest rates in whole life policies or investment performance in universal and variable universal life policies.

It takes several years for a policy to build sufficient cash value for a loan, often two to five years. This accumulated cash value serves as collateral for any loan taken against the policy. The amount available for borrowing is generally a percentage of the cash value, with many insurers allowing access to up to 90% of the policy’s current cash value.

How Life Insurance Loans Work

A life insurance loan is distinct from a withdrawal of cash value. When a policyholder takes a loan, they are borrowing money from the insurance company, with the policy’s cash value serving as collateral. The cash value remains within the policy and continues to grow, meaning the policy’s underlying value is not depleted by the loan, only encumbered.

Life insurance loans accrue interest, which can be either fixed or variable, depending on the policy terms. Interest rates are often competitive, typically ranging from 5% to 8%, and may be lower than those for personal loans or credit cards.

If the loan and its accrued interest are not repaid, the outstanding balance will reduce the death benefit paid to beneficiaries upon the policyholder’s passing. If the outstanding loan balance, including interest, grows to exceed the policy’s cash value, the policy can lapse, leading to the termination of coverage.

The Application and Repayment Process

Initiating a life insurance loan is straightforward, as the policy’s cash value acts as collateral, eliminating the need for credit checks or a formal approval process.

Policyholders contact their insurance provider to inquire about the available loan amount and request funds. Some insurers offer online portals for checking policy values and requesting loans, while others may require a phone call.

Once the request is made, any necessary forms are completed, which generally involve providing basic information such as the policy number and the desired loan amount. Funds are disbursed directly to the policyholder, often through direct deposit or a check, usually within a few business days to about a week.

Life insurance loans offer considerable flexibility regarding repayment. There is often no fixed repayment schedule, allowing policyholders to repay the loan at their discretion, whether through a lump sum, periodic payments, or simply by letting the loan remain outstanding. However, interest continues to accrue on the outstanding loan balance, regardless of whether payments are being made.

Important Financial Considerations

Life insurance loans generally receive favorable tax treatment; they are not considered taxable income as long as the policy remains in force. This is because the loan is viewed as a debt against the policy’s value, rather than a distribution of income.

However, specific circumstances can trigger tax consequences. If the policy lapses or is surrendered with an outstanding loan, the loan amount, to the extent it exceeds the policy’s cost basis, can become taxable as ordinary income.

A policy may also become a Modified Endowment Contract (MEC) if too much premium is paid into it too quickly. Loans from a MEC are subject to different tax rules, where any loan amount is taxed as ordinary income to the extent of policy gains, and a 10% penalty may apply if the policyholder is under age 59½.

The impact on beneficiaries is significant. Any outstanding loan balance, including accrued interest, will reduce the death benefit paid to the beneficiaries. Policyholders should consider the potential reduction in the intended payout for their beneficiaries. Maintaining regular premium payments and monitoring the loan balance is important to prevent the loan from growing to a point where it could cause the policy to lapse or significantly diminish the death benefit.