How to Take a Loan Against Your Life Insurance

Permanent life insurance policies can accumulate cash value over time, providing a financial resource for policyholders. A life insurance loan allows individuals to access a portion of this accumulated cash value without fully surrendering their policy. This financial tool enables policyholders to use their policy’s value for various needs, such as unexpected expenses or investment opportunities, while keeping their insurance coverage in force. It offers a flexible way to leverage a policy’s growth without terminating its primary benefit.

Understanding Life Insurance Loans

A life insurance loan is an advance of funds taken against the cash value that has built up within a permanent life insurance policy. The policy itself serves as collateral for the loan, meaning the insurer does not need to assess the policyholder’s creditworthiness through traditional means. Unlike a withdrawal, which permanently reduces the policy’s cash value, a loan creates a debt that the policyholder is expected to repay. The policy remains active and continues to provide its death benefit, albeit reduced by any outstanding loan balance.

These loans are available from permanent life insurance policies, such as whole life, universal life, and variable universal life insurance. Term life insurance policies do not build cash value and therefore do not offer a loan feature.

The amount an individual can borrow is based on the accumulated cash value within their policy, typically up to 90% of the policy’s net cash surrender value. The specific percentage is outlined in the policy contract and can vary by insurer and policy type.

A distinct characteristic of life insurance loans is their flexible repayment structure. There is generally no fixed repayment schedule, and the loan is not reported to credit bureaus, which means it does not directly impact a borrower’s credit score. Interest does accrue on the outstanding loan balance, and the rate is specified in the policy contract; these rates can be fixed or variable, often ranging from 5% to 9% annually.

Applying for a Life Insurance Loan

The process of applying for a life insurance loan begins with identifying the available cash value within your policy. Policyholders can find this information on their annual policy statements or by contacting their insurance provider directly. Insurers often provide access to policy details through online portals, phone support, or by mail.

Once the available cash value is determined, the policyholder needs to formally request the loan from their insurance company. This usually involves contacting the insurer’s customer service department via phone or their website to obtain the necessary application forms. Some insurers also offer online self-service options that allow policyholders to initiate the loan request electronically.

When completing the application, policyholders will need to provide essential information, including their policy number, the specific loan amount desired, and personal identification details. The forms may also require a signature to confirm understanding and acceptance of the loan terms and conditions.

After submitting the completed application, the insurer reviews the request and processes the disbursement of funds. The timeline for approval and receiving the funds can vary, but it typically ranges from a few business days to one or two weeks. Funds are commonly disbursed either through direct deposit into the policyholder’s bank account or via a check sent through postal mail.

Managing and Repaying Your Loan

Once a life insurance loan is taken, interest begins to accrue on the outstanding balance. This accrued interest must be paid to prevent the loan balance from growing excessively. Policyholders can choose to repay the loan at their convenience, make partial payments, or even repay the entire amount at once. However, any unpaid interest is added to the loan’s principal balance, leading to compounding interest.

Failing to manage an outstanding loan can have significant consequences for the policy. The loan balance, including any accrued interest, directly reduces the death benefit paid to beneficiaries upon the policyholder’s passing. If the outstanding loan amount, combined with accrued interest, grows to exceed the policy’s available cash value, the policy may lapse. This means the insurance coverage terminates, and the policy’s benefits are lost.

If the policy does lapse with an outstanding loan, it can trigger a taxable event. Repaying the loan, even partially, helps restore the policy’s full death benefit and maintains its cash value growth potential.

Tax Considerations for Life Insurance Loans

Generally, a loan taken against the cash value of a life insurance policy is not considered taxable income as long as the policy remains in force. This is because the loan is viewed as an advance against the policy’s value, rather than a distribution of gain or profit.

However, an exception arises if the life insurance policy lapses or is surrendered while there is an outstanding loan balance. In this situation, the portion of the loan amount that represents the gain within the policy (i.e., the amount borrowed in excess of the premiums paid) can become taxable income to the policyholder in the year of the lapse or surrender. This is often referred to as “phantom income” because cash is not received, but a tax liability is created.

Additionally, the tax treatment of life insurance loans can be altered if the policy is classified as a Modified Endowment Contract (MEC). A policy becomes an MEC if it is overfunded, meaning the premiums paid exceed certain federal tax law limits, specifically failing the “7-pay test.” For MECs, loans are treated as taxable distributions first, up to the amount of gain in the policy. If a loan is taken from an MEC before the policyholder reaches age 59½, not only is the gain taxable, but it may also be subject to an additional 10% federal income tax penalty. This penalty is similar to those applied to early withdrawals from qualified retirement plans.