What Is Insurance You Can Borrow From?

Cash value life insurance includes a savings component that grows over time. This cash value can be accessed by the policyholder during their lifetime, offering a financial resource.

Cash Value Life Insurance Explained

Cash value is a component within certain life insurance policies, separate from the death benefit. A portion of each premium payment is allocated to this account, accumulating over time on a tax-deferred basis. Earnings are not taxed until withdrawn. The growth rate depends on the policy type, ranging from guaranteed interest rates to market-linked returns.

Cash value builds gradually, often taking several years to accumulate. In early policy years, a larger premium percentage establishes this value. It becomes a living benefit, accessible to the policyholder, distinguishing it from the death benefit paid to beneficiaries upon the insured’s passing. Cash value serves as the underlying asset for policy loans.

Types of Policies with Loan Provisions

Policies that build cash value and allow borrowing are permanent life insurance products. These include Whole Life, Universal Life, and Variable Universal Life policies, each structuring cash value accumulation differently. Each policy type’s characteristics impact how its cash value grows, influencing the amount available for loans.

Whole Life

Whole Life insurance policies feature a cash value component that grows at a guaranteed fixed rate. This predictable growth ensures a stable increase in the cash value, making it a reliable source for policy loans over time. Premiums for Whole Life policies typically remain fixed throughout the policy’s duration, contributing consistently to this guaranteed cash accumulation. Some mutual insurance companies may also pay dividends, which can further enhance the cash value, though these are not guaranteed.

Universal Life (UL)

Universal Life (UL) insurance offers more flexibility in premium payments and death benefit amounts, allowing adjustments within certain limits. The cash value in a UL policy generally grows based on an interest rate declared by the insurance company, often with a guaranteed minimum. This flexibility means that while cash value can grow significantly, it also requires careful management to ensure sufficient funds are available for loans, as underpaying premiums could impact its growth.

Variable Universal Life (VUL)

Variable Universal Life (VUL) insurance provides the most flexibility, allowing policyholders to invest the cash value in various sub-accounts, similar to mutual funds. The growth of the cash value in a VUL policy is directly linked to the performance of these underlying investments, offering the potential for higher returns but also carrying market risk. This investment-linked growth means the cash value available for loans can fluctuate, increasing with positive market performance or decreasing if investments perform poorly.

The Mechanics of Policy Loans

A policy loan is not a withdrawal of cash value but rather a loan taken against the policy, with the cash value serving as collateral. The insurance company lends funds from its general account, and the policyholder’s cash value remains intact, continuing to earn interest or dividends. This approach ensures the policy itself remains in force, providing continued coverage.

The amount available for a policy loan is typically a percentage of the accumulated cash value, commonly ranging from 75% to 90%. Insurers have varying rules regarding how much cash value must be accumulated before a loan can be taken and the maximum percentage allowed. The process of obtaining a loan is generally straightforward, often requiring only a simple request form from the insurance carrier, with funds typically transferred within a few business days.

Policy loans accrue interest, which can be either fixed or variable, often ranging between 5% and 8%. This interest is charged on the outstanding loan balance, and if not paid, it will be added to the principal, causing the loan amount to grow over time. Policyholders have flexibility in repayment; they can choose to make regular payments, pay only the interest, or even make no payments at all during their lifetime.

Considerations for Policy Loans

Taking a policy loan carries several financial and policy-level implications that policyholders should carefully consider. One significant aspect is the impact on the policy’s death benefit. If a loan remains outstanding at the time of the insured’s death, the loan balance, plus any accrued interest, will be deducted from the death benefit paid to beneficiaries. This reduction means beneficiaries will receive a smaller payout than the policy’s face amount.

From a tax perspective, policy loans are generally not considered taxable income as long as the policy remains in force. The Internal Revenue Service views these transactions as advances against the policy’s cash value, not as income. However, this favorable tax treatment can change if the policy lapses or is surrendered with an outstanding loan.

If a policy lapses or is surrendered while a loan is outstanding, the unpaid loan amount, to the extent it exceeds the policy’s basis (premiums paid minus dividends received), can become taxable income. This potential tax liability, often referred to as “phantom income,” can result in unexpected tax consequences for the policyholder. Therefore, maintaining the policy in force and managing the loan responsibly are crucial to avoid adverse tax outcomes.