How to Borrow From Your Whole Life Insurance Policy

Whole life insurance, a form of permanent life insurance, offers coverage for an individual’s entire life, distinguishing it from temporary term policies. Beyond providing a guaranteed death benefit to beneficiaries, whole life insurance accumulates cash value over time. This accumulated cash value can serve as a financial resource during the policyholder’s lifetime. One common method for accessing these funds is through a policy loan, allowing policyholders to borrow against the accumulated value.

Understanding Whole Life Cash Value

The cash value within a whole life insurance policy represents a savings component that builds steadily over the policy’s duration. A portion of each premium payment contributes to this cash value, and grows on a tax-deferred basis, meaning earnings are not taxed until they are withdrawn or the policy is surrendered. This tax-deferred growth allows the cash value to compound more efficiently over time.

This accumulation often occurs at a guaranteed interest rate specified within the policy, providing predictable and stable growth regardless of market fluctuations. Many whole life policies, particularly those from mutual insurance companies, may also be eligible to receive dividends. While dividends are not guaranteed, they represent a share of the insurer’s profits and can further enhance the cash value growth, or be used in other ways like reducing premiums or purchasing additional coverage.

The cash value is distinct from the death benefit, which is the amount paid to beneficiaries upon the insured’s death. While the death benefit is the primary purpose of life insurance, the cash value provides a “living benefit” that the policyholder can access during their lifetime. This cash value serves as the direct source for a policy loan, rather than a withdrawal that would permanently reduce the policy’s face amount.

Initiating and Managing a Policy Loan

Accessing the cash value through a policy loan begins by contacting the insurance company and submitting a request form. Unlike traditional bank loans, policy loans do not require a credit check, income verification, or a lengthy approval process, as the policy’s cash value acts as collateral. Most insurers allow policyholders to borrow up to a certain percentage of the cash value, commonly around 90%.

The interest rate on a policy loan can be fixed or variable, often ranging from 5% to 8%. This interest accrues on the outstanding loan balance. Whole life policy loans offer flexible repayment; there is no fixed schedule or mandatory monthly payments. Policyholders can choose to repay the loan in a lump sum, make periodic payments, or even opt not to repay the principal at all.

Even with an outstanding loan, the policy remains in force, and the unborrowed portion of the cash value continues to grow. However, the growth of the borrowed portion of the cash value may be impacted if the policy has a “direct recognition” feature. In direct recognition policies, the insurer might adjust the dividend rate applied to the borrowed portion of the cash value, potentially leading to lower overall dividends on that segment. Conversely, in “non-direct recognition” policies, the entire cash value continues to earn the same dividend rate, regardless of an outstanding loan.

Financial and Tax Considerations of Policy Loans

An outstanding policy loan, including any accrued and unpaid interest, directly reduces the death benefit paid to beneficiaries upon the insured’s death. If the loan is not repaid before the insured’s passing, the loan balance and accumulated interest are subtracted from the death benefit, resulting in a reduced payout to the heirs. Repaying the principal and interest of the loan fully restores the death benefit and the policy’s cash value to their original levels, as if no loan had been taken.

A risk arises if the outstanding loan balance, with accrued interest, exceeds the policy’s cash value. In such a scenario, the policy could lapse, leading to the termination of coverage. This lapse means the policyholder loses their life insurance protection, and beneficiaries would not receive a death benefit. While there is no mandatory repayment schedule, consistently paying at least the interest on the loan helps prevent it from growing too large and jeopardizing the policy’s solvency.

From a tax perspective, policy loans are considered tax-free when taken, as they are viewed as borrowing against your own asset rather than a taxable distribution. This tax-free status holds as long as the policy remains in force. However, an exception occurs if the policy lapses or is surrendered while an outstanding loan exists. If the loan amount, combined with any other withdrawals, exceeds the total premiums paid into the policy (known as the cost basis), the difference can become taxable income. This potential “tax bomb” means that even if the policy’s net cash value is depleted by the loan, the policyholder could still face a substantial tax liability on the gains.