Is It Possible to Borrow From a Life Insurance Policy?

Borrowing from a life insurance policy is possible for individuals holding specific types of coverage. This financial flexibility applies exclusively to policies that accumulate a cash value component, distinguishing them from policies that solely offer a death benefit. Accessing funds through a policy loan provides a unique financial tool for policyholders. This article explains the mechanics of life insurance policy loans, important factors to consider, and the steps involved in obtaining a loan.

Understanding Cash Value Life Insurance

Cash value in a life insurance policy represents a savings component that accumulates over time. This accumulated value grows on a tax-deferred basis, meaning earnings are not taxed until withdrawn or the policy is surrendered. The cash value is the portion of the policy that can be accessed by the policyholder, serving as collateral for a loan.

Permanent life insurance policies, such as whole life, universal life, and variable universal life, are designed to build cash value. These differ from term life insurance, which provides coverage for a specific period and does not accumulate cash value, making it ineligible for policy loans. It typically takes several years, often between 2 to 10 years, for a policy’s cash value to grow to a significant amount that can be borrowed against.

How Life Insurance Policy Loans Operate

A life insurance policy loan is not a withdrawal of your cash value but a loan provided by the insurance company, using your policy’s cash value as collateral. Your policy remains in force, and the underlying cash value continues to grow, potentially accruing interest or dividends, even while a loan is outstanding. The funds for the loan come from the insurer’s general account, not directly from your cash value.

Interest is charged on the loan, typically at a fixed or variable rate set by the insurer, often ranging from 5% to 8%. These rates are generally competitive compared to other borrowing options like personal loans. The interest accrues on the outstanding loan balance, and if not paid, it is added to the principal, increasing the total amount owed.

Policy loans offer considerable repayment flexibility, as there is typically no fixed repayment schedule. Policyholders can repay the loan at their own pace, make periodic payments, or choose not to repay it during their lifetime. However, any unpaid loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries.

Important Considerations for Policy Loans

An outstanding loan balance, including any accrued interest, will directly reduce the death benefit paid to beneficiaries upon the insured’s death. This means beneficiaries will receive a lower payout than the policy’s face amount if the loan is not fully repaid. There is a risk of policy lapse if the outstanding loan balance, combined with accrued interest, grows to exceed the policy’s cash value. Should this occur, the policy could terminate, leading to a loss of coverage and potentially significant tax consequences. To prevent a lapse, policyholders must ensure the loan balance remains below the available cash value.

Policy loans are generally not considered taxable income as long as the policy remains in force. However, if the policy lapses or is surrendered with an outstanding loan, the amount of the loan that exceeds the premiums paid (cost basis) could become taxable income. For policies classified as Modified Endowment Contracts (MECs), loans may be taxable and subject to a 10% penalty if the policyholder is under age 59½.

A withdrawal permanently reduces the cash value and the death benefit, and can be taxable if the amount withdrawn exceeds the premiums paid. In contrast, a loan does not permanently reduce the cash value, as the cash value serves as collateral, and it is generally tax-free unless the policy lapses. Policy loans typically do not require a credit check and do not impact the policyholder’s credit score.

The Process of Taking a Policy Loan

The process of taking a policy loan is straightforward. The first step is to contact the insurance company that issued the policy. This can be done by phone, through an online portal, or by submitting a formal loan request form. Policyholders will need to provide their policy number and specify the desired loan amount.

The insurer will confirm the available cash value to ensure the requested loan amount is within the policy’s limits, which is often up to 90% of the cash value. Once the request is approved, which usually occurs quickly due to the nature of the loan, the funds are disbursed. Many insurers can transfer the loan money directly to a bank account within a few days.