What Is a Life Insurance Policy You Can Borrow Against?

Life insurance policies can offer more than just a death benefit; some types also accumulate a cash value that policyholders can access during their lifetime. This cash value provides a financial resource, offering liquidity from a long-term product.

Policies with Cash Value

Certain types of life insurance policies are designed to build cash value over time, distinguishing them from term life insurance, which only provides a death benefit for a specific period. These permanent life insurance policies include whole life insurance and universal life insurance. Whole life insurance offers a guaranteed death benefit, fixed premiums, and a cash value component that grows at a predictable rate. Universal life insurance, while also permanent, provides more flexibility in premium payments and death benefit adjustments, with its cash value growth often tied to interest rates set by the insurer or market performance.

The cash value within these policies is separate from the death benefit. As premiums are paid, a portion is allocated to this cash value account, allowing it to accumulate over the policy’s lifetime. This cash value can be accessed by the policyholder, including through loans.

How Cash Value Accumulates

A portion of each premium payment contributes to the cash value fund within permanent life insurance policies. This portion is distinct from the amount covering the cost of insurance and administrative fees. For whole life policies, the cash value typically grows at a fixed interest rate guaranteed by the insurer, providing predictable growth.

Participating whole life policies may also earn dividends, a share of the insurer’s profits. While not guaranteed, these dividends can be used to purchase additional insurance, reduce future premium payments, or be received as cash, further contributing to the policy’s value. Universal life policies build cash value based on interest rates set by the insurer or linked to market performance, though they typically include a guaranteed minimum interest rate. This tax-deferred growth allows the cash value to compound over time without annual taxation on the earnings.

Understanding Policy Loans

Taking a loan against a life insurance policy’s cash value is a common way to access funds. This process is not a withdrawal of your own money but rather a loan from the insurance company, using your policy’s cash value as collateral. There is typically no credit check or extensive approval process involved, as the loan is secured by the policy’s own value. The amount that can be borrowed is usually limited to a percentage of the accumulated cash value, often up to 90% or 95%.

Interest accrues on policy loans, with rates generally ranging from 5% to 8%. These rates can be fixed or variable, depending on policy terms. While a loan is outstanding, the policy remains in force. However, if the loan is not repaid, the outstanding balance, including accrued interest, will reduce the death benefit paid to beneficiaries.

Managing Policy Loan Balances

Policy loans offer considerable flexibility regarding repayment, differing from conventional bank loans which often have strict repayment schedules. Policyholders can choose to repay the loan at their discretion, including making periodic payments of principal and interest, paying only the interest, or even making no payments at all. However, interest continues to accrue on the outstanding loan balance, and if not paid, it will be added to the principal, increasing the total amount owed.

Unmanaged policy loans and accruing interest can impact the policy’s long-term viability. If the outstanding loan balance, along with accumulated interest, exceeds the policy’s cash value, the policy can lapse. A policy lapse means insurance coverage terminates, and the insurer may surrender the policy to recover the loan amount. This scenario results in loss of coverage and significantly reduces the death benefit.

Tax Considerations for Policy Loans

Policy loans are generally not considered taxable income when they are taken, as long as the policy remains in force. This tax-free access to funds is a notable feature of cash value life insurance. However, there are circumstances under which a policy loan can become taxable. If the policy lapses or is surrendered while an outstanding loan balance exists, and the loan amount, combined with any prior withdrawals, exceeds the policy’s cost basis (the total premiums paid less any dividends received), the gain becomes taxable as ordinary income.

A specific rule applies to policies designated as Modified Endowment Contracts (MECs), which are life insurance policies that have received too much premium too quickly under federal tax law. Loans taken from an MEC are treated differently; they are taxed on a “gain first” basis, meaning any portion of the loan that represents policy gains is immediately taxable as ordinary income. If the policyholder is under age 59½ when taking a loan from an MEC, any taxable gain may also be subject to an additional 10% federal tax penalty.