How to Take a Loan Out of Your Life Insurance

A loan from a life insurance policy offers a way to access funds accumulated within a permanent life insurance contract. Unlike traditional loans, these are not external debts but advances against the policy’s own cash value. The policyholder is essentially borrowing from their own asset, using the cash value as collateral for the loan. The process generally does not involve credit checks or a formal approval process, making it a distinct financial tool.

Policy Eligibility and Loan Basics

Life insurance policies that accumulate cash value, primarily permanent types like whole life and universal life, allow policyholders to take out loans. Term life insurance policies do not offer this feature because they do not build cash value. The cash value component within a permanent policy grows over time from premium payments and credited interest, creating a living benefit accessible during the policyholder’s lifetime.

This accumulated cash value serves as collateral for the loan, meaning the insurance company is lending money against the policy’s own assets. The amount available is typically a percentage of the cash value, commonly up to 90% or 95%. Newer policies may take several years to build significant cash value. Before considering a loan, policyholders should gather essential information such as their policy number, the current accumulated cash value, and details of any existing loans.

The Loan Application Process

Initiating a loan from a life insurance policy is often a straightforward procedure. Policyholders can contact their insurance provider via phone, online portal, or mail to request a loan. While some insurers may require a specific loan request form, many have streamlined the process.

After the request is submitted, processing times are generally quick, often ranging from three to ten business days. Funds can be disbursed through various methods, including direct deposit or check.

Understanding Loan Terms and Repayment

When a loan is taken from a life insurance policy, interest begins to accrue on the outstanding balance. This interest typically accrues daily and is charged at the policy’s anniversary date. Interest rates for policy loans can vary, commonly ranging from 5% to 8% annually, and may be fixed or variable depending on the policy and insurer.

Life insurance loans have a flexible repayment structure. Policyholders can make payments at their discretion, pay only the interest, or choose not to repay the loan during their lifetime. Not repaying the loan has consequences. An outstanding loan balance, along with accrued interest, will reduce the policy’s death benefit paid to beneficiaries.

If the loan balance, including interest, grows to exceed the policy’s cash value, the policy could lapse, resulting in a loss of coverage. This can undermine the primary purpose of the insurance policy. Managing the loan and making at least interest payments is advisable to prevent this outcome and preserve the policy’s integrity.

Tax Considerations

Generally, loans taken from a life insurance policy are not considered taxable income as long as the policy remains in force. This tax treatment is based on the Internal Revenue Service (IRS) viewing these transactions as an advance against the policy’s own value rather than a distribution of gains. However, specific scenarios can trigger tax liabilities.

A policy loan can become taxable if the policy lapses or is surrendered with an outstanding loan balance. In such cases, the amount of the loan that exceeds the policyholder’s “basis” (total premiums paid less any dividends received) may be subject to income tax.

The Modified Endowment Contract (MEC) classification is another consideration. If a policy fails the “7-pay test,” meaning premiums paid exceed a certain limit within the first seven years, it becomes a MEC, which changes the tax rules for loans and withdrawals. Distributions from a MEC, including loans, are taxed on a “last-in, first-out” basis, meaning gains are taxed first, and may also be subject to a 10% penalty if the policyholder is under age 59½. Interest paid on policy loans is typically not tax-deductible. Consulting a qualified tax professional is advisable for personalized guidance.