What Is an Insurance Policy You Can Borrow From?

Life insurance primarily protects beneficiaries upon the policyholder’s passing. However, certain life insurance policies offer an additional feature: the ability to access accumulated funds during the policyholder’s lifetime. This borrowing feature is typically associated with permanent life insurance policies that build cash value. Understanding these policy types and how this mechanism operates is important for those considering such financial tools.

Understanding Policies with Cash Value

Cash value represents a savings component within certain permanent life insurance policies. As premiums are paid, a portion is allocated to the death benefit, another covers insurer costs, and the remainder contributes to this cash value account. This accumulated cash value grows over time, often on a tax-deferred basis, and can be accessed by the policyholder during their lifetime.

Two primary types of permanent life insurance policies accumulate cash value: whole life and universal life insurance. Whole life policies offer guaranteed cash value growth at a fixed interest rate, providing a predictable accumulation path. Premiums for whole life insurance remain level throughout the policy’s duration, and the cash value grows according to a predetermined formula.

Universal life insurance policies offer more flexibility in premium payments and cash value accumulation. While they often provide a guaranteed minimum interest rate, the cash value growth rate can fluctuate based on current interest rates or investment performance. Some universal life variations, such as indexed universal life, tie cash value growth to market indexes, potentially offering higher returns but also greater variability. The presence and growth of this cash value are prerequisites for accessing funds through a policy loan.

The Mechanics of Policy Loans

A policy loan allows a policyholder to borrow funds directly from the insurance company, using the policy’s accumulated cash value as collateral. The cash value itself is not withdrawn; it secures the loan, enabling the policy to remain in force. Unlike traditional bank loans, obtaining a policy loan typically does not require a credit check or formal approval, provided sufficient cash value is available. Insurers generally allow borrowing up to 90% of the cash value.

Interest accrues on the outstanding loan balance, and this interest can be fixed or variable, depending on the policy’s terms. Policy loans do not have a fixed repayment schedule, offering flexibility in how and when they are repaid. While repayment is optional during the policyholder’s lifetime, any unpaid loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries.

If the loan balance, including accrued interest, exceeds the policy’s cash value, the policy can lapse. If a policy lapses with an outstanding loan, the loan amount may become taxable income to the extent it exceeds the policyholder’s cost basis (total premiums paid less tax-free distributions). Some policies offer “wash loans” where loan interest is offset by an equal interest rate credited to the loaned cash value. However, the actual mechanics of these loans can be complex, as the crediting rate may not always perfectly offset the loan interest after accounting for policy fees and costs.

Important Factors When Taking a Policy Loan

Taking a loan against a life insurance policy carries several implications. A primary concern is the impact on the policy’s death benefit; any outstanding loan balance, including accrued interest, will directly reduce the amount paid to beneficiaries. This reduction can significantly diminish the financial protection intended for loved ones if the loan is not repaid.

Tax implications are also an important consideration. Generally, policy loans are not considered taxable income as long as the policy remains in force. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount can become taxable. Any gain in the policy (cash value exceeding premiums paid) becomes taxable as ordinary income. If the policy is classified as a Modified Endowment Contract (MEC), any loan taken is taxable as ordinary income to the extent of the gain, and distributions before age 59½ may incur an additional 10% penalty.

Policy performance can also be affected by loans. For policies that pay dividends or credit interest based on the cash value, the portion of cash value used as collateral for a loan might not continue to earn the same rate of return or receive dividends. Some insurers employ a “direct recognition” method, where the interest credited to the loaned portion of the cash value is adjusted, which can impact the policy’s overall growth. Understanding these terms within the policy contract is important before initiating a loan. While policy loans offer flexible access to funds, a proactive repayment plan or careful monitoring of the loan balance is advised to prevent potential policy lapse and unintended tax consequences.