What Happens When You Borrow Against Your Life Insurance?

Permanent life insurance policies like whole life or universal life, build cash value over time. Cash value can be accessed by the policy owner, including through the option of taking a loan. This article will explore the mechanics of these policy loans, their effects on the policy’s value and death benefit, strategies for managing them, and tax considerations.

Understanding Life Insurance Policy Loans

A life insurance policy loan functions as a loan from the insurance company, using the policy’s accumulated cash value as collateral. This is distinct from a withdrawal, as the policy itself remains in force and continues to accrue cash value and potentially dividends. Policy owners are essentially borrowing from the insurer, with their own policy’s cash value securing the borrowed amount. This means there is no credit check or extensive approval process, making it a readily accessible source of funds for policyholders.

The amount available for a loan is typically a percentage of the policy’s cash value, often up to 90% or 95%. It generally takes several years for a permanent life insurance policy to build sufficient cash value to make a loan a viable option, with some policies accumulating enough value for a loan after about 10 years. Interest accrues on the outstanding loan balance, and this interest rate can be fixed or variable, commonly ranging between 5% and 8%.

How Loans Affect Policy Value and Death Benefit

An outstanding policy loan has direct and ongoing implications for the policy’s components. While the cash value serves as collateral, the presence of a loan reduces the net cash value available for future withdrawals or surrender. The policy’s cash value continues to grow, but the loan balance effectively acts as an encumbrance on that value.

Crucially, any outstanding loan balance, including accrued interest, directly reduces the death benefit paid to beneficiaries upon the insured’s passing. For example, if a policy has a $200,000 death benefit and a $20,000 outstanding loan, beneficiaries would receive $180,000. This reduction ensures the insurer is repaid from the policy’s proceeds. The ongoing accrual of interest on the loan can further diminish the net death benefit if not managed, potentially affecting the financial protection intended for beneficiaries.

Managing Your Policy Loan

Life insurance policy loans typically do not come with a mandatory repayment schedule, offering policy owners significant flexibility. However, interest continues to accrue on the loan balance, and this interest can compound annually. Policy owners have several repayment approaches, including making partial payments, repaying the loan in a lump sum, or choosing not to repay it at all.

The consequences of not repaying the loan can be substantial. As mentioned, the outstanding loan balance and accumulated interest will reduce the death benefit. A significant risk arises if the outstanding loan balance, combined with accrued interest, grows to exceed the policy’s cash value. In such a scenario, the policy may lapse, meaning the coverage terminates. If a policy lapses due to an excessive loan, the policy owner could lose their coverage and potentially face adverse tax consequences on the loan amount that exceeded premiums paid.

Tax Considerations for Policy Loans

Generally, life insurance policy loans are not considered taxable income as long as the policy remains in force. This tax-free access to funds is a notable advantage, as it allows policy owners to use their policy’s cash value without immediate tax implications. The Internal Revenue Service (IRS) views these transactions as loans, not withdrawals of earnings.

However, a critical exception to this general rule exists. If the policy lapses or is surrendered while an outstanding loan remains, the portion of the loan that exceeds the policy owner’s cost basis (typically the total premiums paid) may become taxable income. This event, often referred to as a “taxable event,” occurs because the loan is no longer considered a loan against an active policy. It is then treated as a distribution of untaxed gains. Policyholders should carefully monitor their loan balance relative to their cost basis to avoid this potential tax liability.

How Loans Affect Policy Value and Death Benefit

An outstanding policy loan has direct and ongoing implications for the policy’s components. While the cash value serves as collateral, the presence of a loan reduces the net cash value available for future withdrawals or surrender. The policy’s cash value continues to grow, but the loan balance effectively acts as an encumbrance on that value.

Crucially, any outstanding loan balance, including accrued interest, directly reduces the death benefit paid to beneficiaries upon the insured’s passing. For example, if a policy has a $250,000 death benefit and a $50,000 outstanding loan, beneficiaries would receive $200,000. This reduction ensures the insurer is repaid from the policy’s proceeds. The ongoing accrual of interest on the loan can further diminish the net death benefit if not managed, potentially affecting the financial protection intended for beneficiaries.

Managing Your Policy Loan

Life insurance policy loans typically do not come with a mandatory repayment schedule, offering policy owners significant flexibility. However, interest continues to accrue on the loan balance, and this interest can compound annually. Policy owners have several repayment approaches, including making partial payments, repaying the loan in a lump sum, or choosing not to repay it at all.

The consequences of not repaying the loan can be substantial. As mentioned, the outstanding loan balance and accumulated interest will reduce the death benefit. A significant risk arises if the outstanding loan balance, combined with accrued interest, grows to exceed the policy’s cash value. In such a scenario, the policy may lapse, meaning the coverage terminates. If a policy lapses due to an excessive loan, the policy owner could lose their coverage and potentially face adverse tax consequences on the loan amount that exceeded premiums paid.

Tax Considerations for Policy Loans

Generally, life insurance policy loans are not considered taxable income as long as the policy remains in force. This tax-free access to funds is a notable advantage, as it allows policy owners to use their policy’s cash value without immediate tax implications. The Internal Revenue Service (IRS) views these transactions as loans, not withdrawals of earnings.

However, a critical exception to this general rule exists. If the policy lapses or is surrendered while an outstanding loan remains, the portion of the loan that exceeds the policy owner’s cost basis (typically the total premiums paid) may become taxable income. This event, often referred to as a “taxable event,” occurs because the loan is no longer considered a loan against an active policy. It is then treated as a distribution of untaxed gains. Policyholders should carefully monitor their loan balance relative to their cost basis to avoid this potential tax liability.