What Is Considered Collateral on a Life Insurance Policy Loan?

A life insurance policy loan enables a policyholder to borrow money directly from their insurance company. Unlike traditional loans that might require extensive applications or credit checks, a policy loan leverages the policy’s own value as security, providing a streamlined way to access liquidity. The process is distinct from withdrawing funds, as the policy remains in force, and the loan is against its accumulated worth rather than a direct reduction of its principal.

Understanding Policy Cash Value

Cash value is a component found in permanent life insurance policies, such as whole life or universal life, distinguishing them from term life insurance which does not build cash value. This cash value represents a savings or investment element that grows over time. A portion of each premium payment contributes to this cash value, which then accumulates interest or investment gains on a tax-deferred basis.

The rate at which cash value grows depends on the policy type. Whole life policies often have a guaranteed interest rate, while universal life policies may have a variable rate or one tied to market performance. It typically takes several years for a policy to build a substantial cash value. This accumulated cash value can be accessed by the policyholder during their lifetime for various financial needs.

Cash Value as Collateral

The cash value within a permanent life insurance policy serves as the direct collateral for a life insurance policy loan. When a policyholder takes out such a loan, they are borrowing against their own accumulated funds, with the policy’s cash value securing the debt. No external assets, such as a home or other investments, are required to secure the loan. The insurance company places a lien against a portion of the policy’s cash value equal to the loan amount plus any accruing interest.

The loan amount is typically limited to a percentage of the policy’s cash value, often up to 90%. This internal collateral arrangement simplifies the borrowing process, as there is generally no credit check or lengthy approval process involved.

Loan Mechanics and Repayment

When taking a life insurance policy loan, the funds are provided by the insurance company, not directly withdrawn from the policy’s cash value. The cash value continues to grow, potentially earning interest or dividends, even while a loan is outstanding. Interest accrues on the loan balance, which can range from approximately 5% to 8%.

Repayment of a life insurance policy loan offers significant flexibility. There is generally no fixed repayment schedule, and policyholders can choose to repay the loan at their own pace, or even opt not to repay it at all. However, interest on the loan will continue to accrue and can compound if not paid, increasing the outstanding balance. Life insurance policy loans are not typically reported to credit bureaus, meaning they do not directly impact a policyholder’s credit score.

Policy and Beneficiary Implications

An outstanding life insurance 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.

If the outstanding loan amount, along with accrued interest, grows to exceed the policy’s cash value, the policy can lapse. A policy lapse means the coverage terminates, and the policyholder loses their life insurance protection. If a policy lapses with an outstanding loan, the unpaid loan balance may become taxable income to the extent it exceeds the policyholder’s cost basis (premiums paid). This can create an unexpected tax liability.