Life Insurance Policies You Can Borrow From

Life insurance policies offer a death benefit to beneficiaries. Some policies also allow policyholders to access funds during their lifetime, providing financial flexibility for various needs. Understanding these policies and how they operate is important for leveraging life insurance as a comprehensive financial tool.

Life Insurance Policies That Build Cash Value

Permanent life insurance policies are designed to provide coverage for an individual’s entire life and offer the ability to access funds during one’s lifetime. The two primary types that build cash value are Whole Life and Universal Life policies. These differ from term life insurance, which provides coverage for a specific period and does not accumulate cash value.

Whole Life insurance policies feature guaranteed cash value growth and fixed premiums. A portion of each premium payment is allocated to the policy’s cash value, growing at a guaranteed interest rate set by the insurer. This provides predictable growth and a stable financial component. The death benefit also remains level throughout the policy’s duration.

Universal Life insurance policies offer more flexibility regarding premiums and the death benefit. While a portion of the premium contributes to cash value, its growth can be tied to various factors, including market performance or a fixed interest rate, often with a guaranteed minimum. This flexibility allows policyholders to adjust premium payments or reduce the death benefit, influencing cash value accumulation.

The Role of Policy Cash Value

Cash value is a distinct component within permanent life insurance policies, separate from the death benefit. It functions as a savings element that accumulates over time, providing a financial resource accessible to the policyholder while they are still alive. A portion of each premium payment is directed into this account, which then grows on a tax-deferred basis, meaning earnings are not taxed until withdrawn or the policy is surrendered. This cash value serves as a living benefit, distinct from the death benefit paid to beneficiaries upon the insured’s death.

The primary function of cash value, in the context of accessing funds, is its role as collateral. Policyholders can borrow against this accumulated value, using it as security for a loan from the insurance company. This collateralization allows for access to funds without liquidating the policy or forfeiting the death benefit, as long as the policy remains in force. The cash value’s dual nature as a growing savings component and loan collateral provides financial utility beyond just the death benefit.

How Life Insurance Policy Loans Work

When a policyholder takes a loan against their life insurance, it is a loan from the insurer, not a direct withdrawal of the cash value itself. The cash value serves as collateral, allowing it to continue growing even while a loan is outstanding. The loan process generally does not involve credit checks or extensive approval procedures, as the policy’s cash value secures the loan.

Interest accrues on the outstanding loan balance, with the rate set by the insurance company. While often competitive, this interest compounds, increasing the total amount owed over time. Policy loans offer flexibility in repayment; there is generally no strict schedule, and policyholders can choose to repay the loan at their convenience, or not at all.

If the loan, including accrued interest, is not repaid, it will reduce the death benefit paid to beneficiaries. A risk arises if the loan balance, along with accrued interest, grows to exceed the policy’s cash value. In such cases, the policy can lapse, leading to a loss of coverage.

Important Considerations for Policy Loans

Policy loans are generally not considered taxable income as long as the policy remains in force. The IRS views these transactions as an advance against the policy’s cash value rather than a taxable distribution. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount exceeding the policy’s basis (typically total premiums paid) can become taxable as ordinary income.

If the loan balance, including accumulated interest, exceeds the available cash value, the policy can terminate. This results in loss of coverage and can trigger a taxable event on the outstanding loan amount. Many policies have an automatic premium loan feature, which uses cash value to cover missed premium payments, potentially accelerating the erosion of cash value if not managed carefully.

An outstanding loan directly impacts the policy’s long-term value and the death benefit. Any unpaid loan amount, plus accrued interest, will be deducted from the death benefit paid to beneficiaries, which can significantly diminish the financial protection intended for loved ones. While the cash value continues to grow with a loan outstanding, the interest charged on the loan can counteract some of this growth, affecting the policy’s overall performance and accumulation over time.