What Is a Policy Loan and How Does It Work?

A policy loan is a financial tool available through certain types of life insurance policies, allowing policyholders to borrow money against the accumulated value within their policy. This method differs from traditional loans, involving access to your policy’s cash value rather than borrowing from an external lender. It provides a way to access financial resources built within a life insurance contract while keeping the policy in force.

Understanding Policy Loans

A policy loan uses the accumulated cash value of a permanent life insurance policy as collateral. Unlike a conventional bank loan, the insurance company does not typically require a credit check or a lengthy approval process because the policyholder accesses their own funds, secured by the policy itself. This means the loan is not reported to credit bureaus and does not affect one’s credit score.

Policy loans are available only from permanent life insurance policies, which are designed to last for the insured’s entire life and build cash value over time. Common types include whole life, universal life, and variable universal life policies. Term life insurance policies do not accumulate cash value and therefore do not offer policy loans.

Cash value accumulates as a portion of each premium payment is allocated to a savings component, growing on a tax-deferred basis. Whole life cash value grows at a guaranteed rate and may earn dividends. Universal life policies offer flexible premiums and growth tied to interest rates or market performance. Variable universal life policies allow investment in sub-accounts, offering potential for higher returns but also greater risk.

How Policy Loans Work

Initiating a policy loan involves submitting a request to the insurance company. The amount that can be borrowed is determined by the available cash value, with many insurers allowing access to up to 90% of this amount. There are no restrictions on how the borrowed funds can be used.

Interest accrues on the outstanding loan balance. This interest can be fixed or variable, depending on policy terms, and typically ranges from 5% to 8%. If interest is not paid, it is added to the outstanding loan balance, increasing the total amount owed.

Despite taking a loan, the policy’s cash value continues to earn interest or dividends, although the loan amount is held as collateral. The policy remains in force, providing coverage as long as premiums are paid and the loan balance does not exceed the cash value. This allows policyholders to access liquidity without surrendering their policy or disrupting its long-term benefits.

Implications of Taking a Policy Loan

Taking a policy loan has several direct financial consequences. The most immediate impact is that the portion of the cash value used for the loan becomes collateralized. This reduces the accessible cash value available for future needs.

The death benefit paid to beneficiaries is reduced. If a loan, including accrued interest, remains outstanding when the insured passes away, that balance is deducted from the death benefit. This can substantially decrease the amount beneficiaries receive.

There is a risk of policy lapse if the outstanding loan balance, compounded by accrued interest, exceeds the policy’s cash value. If this occurs, the insurance company can terminate the policy, leaving the policyholder without coverage. A lapse can trigger adverse tax consequences, as any gain on the policy (loan amount exceeding premiums paid) may become taxable as ordinary income. For Modified Endowment Contracts (MECs) under Internal Revenue Code Section 7702, loans may be subject to immediate taxation and penalties if taken before age 59½.

Managing and Repaying Policy Loans

Policy loans have a flexible repayment structure, differing from traditional loans with fixed payment schedules. Policyholders are not required to adhere to a rigid repayment plan; they can choose to repay the principal and interest at their convenience, make periodic payments, or simply pay the interest. Some policyholders make no repayments during their lifetime.

However, if the loan, including accrued interest, is not repaid before the insured’s death, the outstanding balance will be subtracted from the death benefit. The continued accumulation of interest on an unpaid loan can also erode the policy’s cash value.

Effective management of a policy loan prevents the loan balance from surpassing the policy’s cash value, which could lead to policy lapse and tax liabilities. Repaying the loan helps restore the full cash value and death benefit, ensuring the policy functions as intended.