What Is a Life Insurance Policy You Can Borrow From?

A life insurance policy that allows for borrowing is a financial tool offering both a death benefit and a savings component. These policies accumulate cash value over time, which policyholders can access during their lifetime, typically as a loan. This ability distinguishes permanent life insurance products from term insurance, which generally does not build cash value.

Understanding Life Insurance Cash Value

Cash value is a portion of premium payments that grows within permanent life insurance policies. This accumulated amount is distinct from the death benefit paid to beneficiaries. As premiums are paid, a segment contributes to the cash value, which typically earns interest or dividends.

Cash value growth can be guaranteed or vary depending on market performance, as outlined by policy terms. Policyholders can access this cash value during their lifetime for various financial needs. This cash value component provides a living benefit, offering a financial resource while the policy remains in force.

Types of Policies with Loan Provisions

Several types of permanent life insurance policies build cash value, enabling policyholders to take out loans. These policies differ in how their cash value accumulates and the flexibility they offer, linking cash value directly to loan eligibility.

Whole life insurance offers a guaranteed cash value growth rate and a fixed premium throughout the policy’s life. Its cash value grows predictably, making it a stable source for policy loans. This policy provides consistent accumulation, allowing for loans based on its established value.

Universal life insurance provides more flexibility with premium payments and death benefits than whole life. Its cash value growth is tied to an interest rate, which can be guaranteed or adjustable. Policyholders can take loans against the accumulated cash value, influenced by the policy’s interest crediting rate and associated fees.

Variable universal life insurance allows policyholders to invest cash value in various sub-accounts, similar to mutual funds. Cash value growth is not guaranteed and fluctuates based on investment performance. These policies permit loans against the cash value, collateralized by the policy’s current value.

The Policy Loan Process

Initiating a policy loan involves a direct request to the insurance company. The loan amount is typically limited to 75% to 90% of the policy’s net cash surrender value. This process does not require a credit check or a traditional loan application, as the policy’s cash value serves as collateral.

A policy loan is not a withdrawal from the cash value; it is a loan against the policy itself. The cash value remains as collateral, continuing to earn interest or dividends, though the portion securing the loan may have its growth rate adjusted. The policy remains in force, and the death benefit continues, reduced by any outstanding loan balance.

Interest accrues on the loan, with the rate specified in the policy contract, which can be fixed or variable. Policyholders have flexibility in repaying the loan, with no strict schedule mandated by the insurer. If the loan and its accrued interest are not repaid, the outstanding balance will reduce the death benefit.

Interest paid on a policy loan affects the policy’s performance and cash value. Unpaid loan interest can be added to the outstanding loan balance, causing it to grow. If the total loan balance, including accrued interest, exceeds the policy’s cash value, the policy could lapse, potentially triggering adverse tax consequences.

Financial Aspects of Policy Loans

Policy loans are generally not considered taxable income when taken out by the policyholder, as they are borrowing their own money with the policy’s cash value as collateral. This non-taxable status can change if the policy lapses or is surrendered with an outstanding loan.

If a policy is classified as a Modified Endowment Contract (MEC) due to overfunding, loans are treated differently. For MECs, loans are considered distributions and are taxed on a last-in, first-out (LIFO) basis. Additionally, withdrawals or loans from a MEC may be subject to a 10% penalty if the policy owner is under age 59½.

Any outstanding loan balance, including accrued interest, reduces the death benefit paid to beneficiaries. For example, if a policy has a death benefit of $400,000 and an outstanding loan of $40,000, beneficiaries would receive $360,000. This reduction ensures the insurer recovers the loaned funds.

An outstanding loan affects the policy’s cash value growth. While the cash value continues to earn interest, the loan accrues interest. If loan interest is not paid, it can be added to the principal, causing the loan balance to increase. This growing balance can erode the policy’s cash value, potentially leading to a policy lapse if the loan amount, plus accrued interest, exceeds the remaining cash value.