What Is a Life Insurance Policy You Can Borrow From?

Life insurance policies offer financial protection to beneficiaries upon the policyholder’s passing. Some policies also provide living benefits, allowing access to accumulated funds during the insured’s lifetime. This feature is generally available with policies that build cash value.

Policies That Allow Borrowing

Certain types of life insurance policies accumulate a cash value, a savings component separate from the death benefit, which policyholders can access. The primary policies offering this feature are Whole Life and Universal Life insurance, both forms of permanent life insurance. Term life insurance, designed for coverage over a specific period, does not build cash value and therefore does not offer a borrowing option.

Whole Life insurance policies feature a cash value component that grows at a guaranteed rate, providing predictability. A portion of each premium payment contributes to this cash value, which earns interest on a tax-deferred basis.

Universal Life insurance policies also build cash value, but their growth is often tied to interest rates set by the insurer or linked to market performance. While they offer more flexibility in premium payments, cash value growth can be variable. For example, Indexed Universal Life (IUL) policies tie cash value growth to a stock market index, with a floor and cap on returns.

The cash value component in these permanent policies is distinct from the death benefit. As premiums are paid, part contributes to the cash value. This accumulated cash value can be borrowed against.

Understanding Policy Loans

A life insurance policy loan is a financial transaction where the policyholder borrows money from the insurance company, using the policy’s accumulated cash value as collateral. This is not a withdrawal of the policyholder’s own money, but rather a loan provided by the insurer. The cash value secures the loan, meaning the loan amount is typically limited to a percentage of the cash value, often up to 90%.

One distinct advantage of a life insurance policy loan is that it generally does not require a credit check or a lengthy application process. Since the policy’s cash value serves as collateral, the approval process is often straightforward, with funds potentially available within a few days. This makes it a readily accessible source of funds for policyholders.

Interest is charged on the loan, similar to any other borrowing. The interest rates for policy loans are typically competitive, often ranging from 5% to 8%, which can be lower than rates for personal loans or credit cards. This interest accrues on the outstanding loan balance, and it can be either a fixed or variable rate, depending on the policy terms.

The cash value within the policy generally continues to grow and earn interest or dividends, even while a loan is outstanding. This means the policy’s financial components remain active, although the net cash value available might be reduced by the loan amount. The loan itself does not affect the policyholder’s credit report because it is a loan from the insurer, secured by the policy’s internal value.

Managing Your Policy Loan

After taking a life insurance policy loan, policyholders have flexibility regarding repayment. Unlike conventional loans, there is typically no strict repayment schedule, and repayment is often optional. However, interest continues to accrue on the unpaid loan balance. Policyholders can choose to make regular payments, pay only the interest, or even make no payments at all, allowing the interest to be added to the principal.

An outstanding policy loan, including any accrued interest, directly reduces the death benefit paid to beneficiaries. If the policyholder passes away with an unpaid loan, the insurance company will deduct the outstanding balance from the death benefit before distributing the remainder to the beneficiaries. This can significantly diminish the financial protection intended for loved ones.

The tax implications of a policy loan become relevant if the policy lapses or is surrendered with an outstanding loan balance. While the loan itself is generally not considered taxable income as long as the policy remains in force, a different situation arises if the policy’s cash value falls below the loan amount, leading to a lapse. In such a scenario, the outstanding loan amount that exceeds the policy’s cost basis (the total premiums paid, less any prior untaxed distributions) can be treated as taxable income by the Internal Revenue Service (IRS) under IRC Section 72.

This taxable event occurs because the IRS views the outstanding loan in a lapsed policy as if the policyholder received that amount as a distribution. Therefore, if the loan balance surpasses the amount of premiums paid into the policy, the difference can become taxable as ordinary income. To avoid such consequences, it is advisable to monitor the loan balance regularly and ensure the policy’s cash value remains sufficient to support the loan and prevent a lapse.