Types of Life Insurance You Can Borrow From

Life insurance policies can offer more than just a death benefit; certain types also provide a financial resource accessible during the policyholder’s lifetime. This access is rooted in the policy’s cash value, which builds over time. A portion of premiums contributes to this cash value, growing on a tax-deferred basis. This accumulated value serves as collateral, allowing policyholders to access funds without disrupting coverage.

Policy Types Allowing Loans

Permanent life insurance policies accumulate cash value, which serves as the basis for policy loans. Whole Life and Universal Life insurance are the most common types offering this feature. Each builds cash value differently, reflecting unique structures and growth mechanisms.

Whole Life insurance policies feature guaranteed cash value accumulation at a predetermined rate. A portion of each premium is allocated to this cash value, ensuring steady growth over the policy’s lifetime. This guaranteed growth provides a reliable fund for policyholders to borrow against.

Universal Life insurance offers more flexibility in premium payments and death benefits, influencing cash value growth. Cash value in a Universal Life policy grows based on an interest rate credited to the account, which can be fixed, variable, or tied to an external index. This flexibility allows policyholders to adjust premiums, impacting cash value accumulation and the amount available for a loan. Both policy types create a pool of funds that, once accumulated, can be leveraged through a policy loan.

Understanding Policy Loans

A policy loan is a financial arrangement where the policyholder borrows money from the insurer, using the policy’s accumulated cash value as collateral. This is not a withdrawal of the cash value itself, but rather a loan against it. The policy remains in force, and the cash value continues to exist, securing the borrowed amount.

The amount a policyholder can borrow is typically a percentage of the cash surrender value, often ranging from 75% to 90% of the available cash value. Insurers determine this maximum loan amount to ensure sufficient collateral remains in the policy. The loan amount can fluctuate over time as the cash value grows or decreases due to other policy transactions.

Interest is charged on the outstanding loan balance, and this interest rate can be either fixed or variable, often ranging from 5% to 8% annually. This interest accrues daily or monthly and is added to the total loan balance if not paid by the policyholder. The policyholder pays this interest to the insurer.

An outstanding policy loan directly reduces the death benefit payable to beneficiaries. If the policyholder passes away with an unpaid loan, the outstanding loan balance, plus any accrued interest, is subtracted from the death benefit amount. This reduction ensures that the insurer recovers the advanced funds before the remaining death benefit is disbursed.

While a loan is outstanding, the policy’s cash value generally continues to grow, although the portion of the cash value used as collateral may earn interest at a different rate, or the overall growth may be affected. Some policies may have a “direct recognition” feature, meaning the cash value supporting the loan earns a lower or zero interest rate. Other policies operate under “non-direct recognition,” where the entire cash value continues to earn interest as if no loan were taken, even though the insurer charges interest on the loan. The specific terms outlined in the policy document detail how cash value growth is impacted during the loan period.

Managing and Repaying Policy Loans

Managing a policy loan involves understanding its flexible repayment structure and the potential consequences of non-repayment. Unlike traditional bank loans, policy loans often do not have mandatory repayment schedules or fixed monthly payments. Policyholders have the flexibility to repay the loan at their convenience, or they may choose not to repay it at all.

However, interest continues to accrue on the outstanding loan balance, increasing the total amount owed. If this interest is not paid, it is typically added to the principal loan amount, leading to compound interest and a steadily growing loan balance. This accumulating balance can eventually become a significant financial consideration, impacting the policy’s long-term viability.

A critical risk arises if the loan balance, including accrued interest, grows to exceed the policy’s cash surrender value. Should this occur, the policy may lapse, meaning it terminates due to insufficient funds to cover its costs. If a policy lapses with an outstanding loan, the policyholder could face immediate tax consequences, as the outstanding loan amount may be treated as taxable income up to the policy’s basis.

Voluntary repayments can be made at any time, in any amount, or frequency, without penalty. Each repayment reduces the outstanding loan balance, which in turn reduces the amount of accrued interest. Repaying the loan also restores the policy’s full cash value and death benefit, ensuring that the original coverage amount is available to beneficiaries. This flexibility allows policyholders to manage their financial obligations and maintain the integrity of their life insurance coverage.

Tax Treatment of Policy Loans

Policy loans generally receive favorable tax treatment, as they are not considered taxable income when taken. This is because the loan is viewed as an advance of funds from the insurer, secured by the policy’s cash value, rather than a distribution of earnings. As long as the policy remains in force, loan proceeds are not subject to income tax.

However, a policy loan can become taxable under specific circumstances. If the policy lapses or is surrendered while a loan is outstanding, the loan amount, up to the policy’s basis (premiums paid less dividends received), may be considered taxable income. This occurs because the loan is no longer secured by the policy, and the untaxed gain is effectively realized. The taxable amount is the lesser of the outstanding loan balance or the policy’s gain.

Another consideration is if the life insurance policy is classified as a Modified Endowment Contract (MEC). A policy becomes a MEC if it fails the “7-pay test,” which limits premiums paid into a policy during its first seven years. If a policy is designated as a MEC, any loans are treated as taxable distributions, similar to withdrawals.

For MECs, loans are subject to a “last-in, first-out” (LIFO) rule, meaning earnings are considered distributed first, making them taxable income. Distributions from a MEC, including loans, taken before age 59½ may be subject to a 10% penalty tax in addition to regular income tax. Understanding a policy’s MEC status is crucial for assessing the tax implications of any loan.