The Best Life Insurance Policies for Borrowing

Life insurance policies can serve purposes beyond providing a death benefit, particularly those that accumulate cash value. This feature enables individuals to borrow against their policy’s cash value, offering a flexible financial tool. This article explores how these policies function and what considerations are important when seeking a policy suitable for borrowing.

Life Insurance Policies Allowing Cash Value Access

Permanent life insurance policies are designed to remain in force for the policyholder’s entire life, accumulating cash value over time. The two primary types of permanent life insurance that offer this feature are Whole Life Insurance and Universal Life Insurance. These policies are distinct from term life insurance, which provides coverage for a specific period and does not build cash value.

Whole Life Insurance offers a guaranteed cash value accumulation rate, meaning growth is predictable and not subject to market fluctuations. Premiums are typically fixed for the life of the policy, with a portion of each payment contributing to the cash value. This cash value grows on a tax-deferred basis and can be accessed through loans or withdrawals.

Universal Life Insurance provides more flexibility in premium payments and death benefits compared to whole life. Its cash value growth is tied to an interest rate, which can be fixed, variable, or indexed to a market benchmark, depending on the specific policy type. This flexibility allows policyholders to adjust premiums or death benefits as their financial needs change. The cash value grows tax-deferred and can be a source for policy loans or withdrawals.

Understanding Policy Loans

Taking a loan against a life insurance policy’s cash value differs significantly from obtaining a traditional loan. When you borrow from your policy, the insurer lends money from its general account, using your policy’s cash value as collateral. There is no credit check required, as the loan is secured by your policy’s value.

Policy loans do not have a fixed repayment schedule, offering considerable flexibility. You can choose to repay the loan at your own pace, or you may decide not to repay it at all. Interest is charged on the outstanding loan balance, and this interest typically ranges from about 4% to 8% annually. If the interest is not paid, it accrues and is added to the outstanding loan principal, increasing the total amount owed.

The amount you can borrow is typically a percentage of your policy’s cash value, often up to 90% or 95%. This limit ensures that a portion of the cash value remains to keep the policy in force. While repayment is encouraged to maintain the policy’s full value, there are no immediate consequences like damaged credit if payments are deferred.

Impact of Policy Loans

Taking a loan from a life insurance policy has several implications for the policy’s performance and benefits. One direct effect is on the death benefit. If the policyholder passes away with an outstanding loan, the death benefit paid to beneficiaries will be reduced by the unpaid loan amount, including any accrued interest. This reduction ensures the insurer recovers the loan amount.

The policy’s cash value continues to earn interest or dividends even while a loan is outstanding. However, it earns on the unencumbered portion of the cash value, which is the total cash value minus the outstanding loan balance. Some policies may have a “wash loan” feature, where the interest credited to the borrowed portion of the cash value is approximately equal to the interest charged on the loan, effectively reducing the net cost of borrowing.

A significant consideration is the potential for the loan interest to exceed the policy’s cash value growth rate. If the accumulated loan balance, including accrued interest, grows faster than the cash value, it can eventually erode the policy’s value. This can lead to the policy lapsing if the outstanding loan balance, plus accrued interest, exceeds the policy’s cash value. A policy lapse due to an outstanding loan can trigger a taxable event under Internal Revenue Code Section 72, where any gain (the cash value received less premiums paid) may become immediately taxable as ordinary income.

Selecting a Policy for Borrowing

When choosing a life insurance policy with the intention of utilizing its borrowing features, several characteristics warrant careful evaluation. The rate at which the cash value accumulates is a primary factor. Policies with robust and consistent cash value growth, such as participating whole life policies that pay dividends, can provide a larger pool of funds for future borrowing. A higher growth rate means more accessible cash value over time.

Loan interest rates offered by the policy are a consideration. Some policies offer fixed loan rates, providing predictability in borrowing costs, while others have variable rates that can fluctuate. Policies with competitive and stable loan interest rates, perhaps in the range of 4% to 6%, are generally more favorable for long-term borrowing strategies. Understanding how loan interest is calculated and applied can prevent surprises.

Specific loan provisions within the policy contract are important, including the flexibility of repayment options and any grace periods for missed interest payments. Some policies may offer more lenient terms for repayment, which can be advantageous during periods of financial strain. For participating whole life policies, the ability of dividends to enhance cash value growth or even offset loan interest through a “wash loan” feature can be a significant benefit. Understanding surrender charges is important. These fees are deducted from the cash value if the policy is terminated and indicate how much of your cash value is truly accessible if you were to surrender the policy.