What Is Life Insurance That You Can Borrow From?

Life insurance policies primarily protect beneficiaries upon the insured’s death. However, certain permanent life insurance policies also offer a living benefit, allowing policyholders to access funds during their lifetime. Unlike term life insurance, permanent policies include a savings component that accumulates cash value over time. This accumulated value can be accessed through various means, including policy loans.

Understanding Cash Value Life Insurance

Cash value is the portion of a permanent life insurance policy that accumulates funds over time, functioning as a savings component. A portion of each premium payment is allocated to this account, growing on a tax-deferred basis. Earnings are not taxed until withdrawn or the policy lapses.

Whole Life and Universal Life policies are the primary types of permanent life insurance that build cash value and allow borrowing. Whole Life insurance offers guaranteed cash value growth, typically at a fixed interest rate (1% to 3.5% annually), fixed premium payments, and a guaranteed death benefit. Some Whole Life policies may also receive dividends, enhancing cash value or reducing premiums.

Universal Life insurance offers flexibility in premium payments and death benefits. Cash value accumulation can vary based on insurer-declared interest rates or market indexes. This adaptability benefits individuals with fluctuating incomes, allowing premium adjustments to maintain coverage. Both policy types require several years for sufficient cash value to accumulate before becoming a resource for loans.

How Policy Loans Work

A policy loan is money borrowed from the insurance company, using the policy’s accumulated cash value as collateral. It is a loan against the cash value, not a withdrawal. The cash value remains within the policy and continues to grow, though the encumbered portion may earn interest at a different rate. The policy generally remains in force with premium payments and sufficient cash value.

Interest accrues on the outstanding loan balance at a rate set by the insurer, which can be fixed or variable. Rates are often competitive (5% to 8%) and can be lower than traditional personal loans. Unpaid interest is added to the loan principal, increasing the balance through compounding.

Repayment is flexible, often without a strict schedule. Policyholders can repay gradually, make interest-only payments, or defer repayment indefinitely. However, any outstanding loan balance, including accrued interest, will be deducted from the death benefit paid to beneficiaries.

Requesting a policy loan is straightforward, often requiring only a form submission. Since the loan is collateralized by the cash value, there is no credit check, and funds are usually accessed quickly, often within days. This accessibility makes policy loans convenient for unexpected financial needs.

Important Considerations for Policy Loans

Understanding tax implications is important. Generally, policy loans are not considered taxable income when received, as the IRS views them as advances against the cash value. However, this tax-free status can change if the policy lapses or is surrendered with an outstanding loan. In such cases, the loan amount exceeding premiums paid may be treated as taxable income, potentially leading to an unexpected tax liability.

A policy can be classified as a Modified Endowment Contract (MEC) if premiums exceed federal tax law limits, failing the “7-pay test.” This status is irreversible. For MECs, distributions, including loans and withdrawals, are taxed on a “last-in, first-out” (LIFO) basis. A 10% federal penalty tax may also apply to the taxable portion if the policyholder is under age 59½.

A risk with policy loans is potential policy lapse. If the outstanding loan balance and accrued interest exceed the policy’s available cash value, the insurer may terminate the policy. This results in loss of coverage and can trigger a taxable event on accumulated gains, as the loan becomes a distribution. Monitoring the loan balance relative to cash value is important to prevent this.

Any outstanding loan balance and accrued interest reduce the death benefit paid to beneficiaries. This can diminish the financial protection for loved ones if the loan is not repaid. While repayment is flexible, managing policy loans responsibly helps maintain the intended death benefit. The portion of cash value used as collateral may also not earn dividends or interest at the same rate as unencumbered cash value, impacting overall cash value growth.