What Is Life Insurance You Can Borrow Against?

Understanding Life Insurance You Can Borrow Against

Certain types of life insurance policies offer more than just a death benefit; they can also build an accessible cash value over time. Policyholders may borrow against this cash value without terminating the policy. These loans function differently from traditional bank loans, utilizing the policy’s own accumulated value as collateral.

Understanding Policy Cash Value

Policy cash value represents a portion of the premiums paid into certain life insurance policies that grows on a tax-deferred basis. It accumulates over the policy’s lifetime, separate from the death benefit amount. This value is distinct from the policy’s face amount, which is the sum paid to beneficiaries upon the insured’s death.

The accumulation of cash value is influenced by a portion of each premium payment, investment growth, or declared interest rates. This accumulated amount can be accessed by the policyholder through withdrawals or loans.

As the cash value grows, it creates a living benefit for the policyholder, offering a financial reserve. This growth is generally not taxed until it is withdrawn from the policy and exceeds the total premiums paid. This tax-deferred growth allows the cash value to compound more efficiently over time.

Types of Life Insurance Policies with Cash Value

Life insurance policies that accumulate cash value primarily include Whole Life and Universal Life insurance. Each type offers a distinct structure for cash value accumulation and premium payments.

Whole Life insurance features fixed premiums and a guaranteed cash value growth rate, alongside a guaranteed death benefit. The cash value component grows predictably over time. A portion of each premium payment is allocated to this cash value, ensuring its steady increase.

Universal Life insurance offers more flexibility in premium payments and death benefits. Its cash value growth is tied to current interest rates, which can fluctuate. This flexibility allows policyholders to adjust payments within certain limits, impacting how quickly the cash value accumulates.

How Policy Loans Work

A policy loan is an advance against the policy’s cash value, where the policy itself serves as collateral. The insurance company lends money to the policyholder, secured by the cash value. A credit check is generally not required to obtain a policy loan.

Interest is charged on the outstanding loan balance, and this interest accrues daily. The interest rates are set by the insurer and can be fixed or variable, often ranging from 5% to 8% annually. While there are no mandatory repayment schedules, any unpaid interest will be added to the principal loan amount, increasing the total debt.

Any outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries upon the insured’s passing. For example, if a policy has a $200,000 death benefit and an outstanding loan of $50,000, beneficiaries would receive $150,000. It is important to monitor the loan balance to prevent unintended reductions in the death benefit.

If the loan balance, along with accrued interest, grows to exceed the policy’s available cash value, the policy can lapse. A policy lapse due to an outstanding loan can have significant tax consequences, as the outstanding loan amount may become taxable income. Insurance companies typically limit the loan amount to a percentage of the cash value, often around 90-95%, to mitigate this risk.

Requesting a Policy Loan

Obtaining a policy loan involves contacting the insurance provider. Policyholders can reach out to their insurer through a customer service line, an online portal, or by contacting their insurance agent.

The insurance company will require specific information, such as the policy number and the desired loan amount. Policyholders will need to complete and submit a loan request form provided by the insurer.

The amount that can be borrowed is limited to a percentage of the policy’s accumulated cash value, commonly around 90% to 95%. Once the request is processed and approved, the funds are disbursed to the policyholder via direct deposit or a check. The processing time for a policy loan can vary, but it often ranges from a few business days to a week.

Tax Implications of Policy Loans

Policy loans are generally not considered taxable income when taken out. This is because they are viewed as a loan against the policy’s value, rather than a distribution of its gains. The Internal Revenue Service (IRS) does not tax the loan principal as long as the policy remains in force.

However, there are exceptions and conditions to this rule. If the policy lapses or is surrendered while a loan is outstanding, the amount of the loan that exceeds the premiums paid into the policy may become taxable as ordinary income. This can occur if the policy’s cash value is insufficient to cover the loan balance, leading to the policy’s termination.

This tax implication is relevant for policies classified as Modified Endowment Contracts (MECs). If a policy is deemed an MEC, loans taken from it are subject to “last-in, first-out” (LIFO) tax accounting rules, meaning gains are considered distributed first and may be taxable. Additionally, withdrawals and loans from MECs before age 59½ may incur a 10% penalty tax on the taxable portion. Interest paid on a policy loan is generally not tax-deductible.