What Is the Collateral on a Life Insurance Policy Loan?

Certain types of life insurance policies accumulate cash value, which policyholders can access during their lifetime. This accumulated value can serve various financial needs, including providing a source for loans. Understanding how these loans function is important, particularly discerning what asset secures such borrowing.

Fundamentals of a Life Insurance Policy Loan

A life insurance policy loan is a financial arrangement taken against the accumulated cash value of a permanent life insurance policy, such as whole life or universal life. The policyholder is essentially borrowing from the insurer, using their own policy’s value as the basis for the loan. Unlike withdrawals, which reduce the cash value permanently, a loan creates a debt against the policy’s value that can be repaid.

These loans do not require a credit check for approval, as the loan is secured by the policy’s internal value. There is typically no fixed repayment schedule, offering flexibility. However, interest accrues on the outstanding loan balance, with rates generally set by the insurer, often ranging between 5% and 8%.

The availability of a loan depends on the policy having sufficient cash value, which usually takes several years to build. Insurers allow policyholders to borrow up to 90% of the policy’s current cash value. While the loan reduces the available cash value and potential death benefit by the outstanding amount, the policy remains in force as long as premiums are paid and the loan balance does not exceed the cash value.

The Collateral for the Loan

The cash value component of a permanent life insurance policy serves as the primary collateral for a life insurance policy loan. When a policyholder takes out a loan, the insurer holds a portion of this cash value, equivalent to the loan amount plus any accrued interest, as security. This internal collateral mechanism distinguishes life insurance loans from conventional loans, which typically require external assets like a home or vehicle as security.

Cash value is suitable collateral due to its guaranteed nature within the policy; it is an amount directly controlled by the insurer. The policyholder is not receiving their own money as a withdrawal; rather, the insurer provides funds from its general account, placing a lien against the policy’s cash value. This means the insurer has a claim against that specific value if the loan is not repaid, ensuring their ability to recover the borrowed funds.

For example, if a policy has a cash value of $50,000 and the policyholder borrows $20,000, the insurer secures this $20,000 against the existing cash value. The cash value itself continues to grow, potentially earning interest or dividends, even while the loan is outstanding. The policy’s face value or death benefit can also be assigned as collateral for external loans, a process known as collateral assignment. In such cases, if the borrower dies before the loan is repaid, the lender can collect the outstanding balance directly from the death benefit.

How Unpaid Loans Affect Policy Value

If a life insurance policy loan, secured by the cash value, remains unpaid, it can have several implications for the policy’s value and future benefits. One consequence is the reduction of the death benefit. Any outstanding loan balance, including accrued interest, will be subtracted directly from the death benefit paid to beneficiaries upon the insured’s death. For instance, if a policy has a $250,000 death benefit and an outstanding loan of $50,000, the beneficiaries would receive $200,000.

An outstanding loan can also impede the future growth of the policy’s cash value. While the portion of the cash value not securing the loan may continue to earn interest or dividends, the encumbered portion might not contribute to growth in the same way, or it may reduce the base upon which new interest or dividends are calculated. This can slow the accumulation of cash value within the policy.

Unpaid loans carry the risk of policy lapse. If the outstanding loan balance, combined with accumulating interest, grows to exceed the policy’s available cash value, the policy can terminate. This situation arises when the policy no longer has sufficient cash value to cover its own charges, such as mortality costs and administrative fees, or to sustain the loan interest. A policy lapse due to an unpaid loan can also trigger unexpected tax liabilities, as the outstanding loan amount may be treated as taxable income if the policy terminates.

Managing and Repaying the Loan

Managing a life insurance policy loan involves understanding how interest accrues and the available repayment options. Interest on policy loans typically accrues annually and, if not paid, is added to the principal loan balance, causing the debt to grow over time through capitalization. This compounding of interest can significantly increase the total amount owed if not addressed.

Policyholders have flexibility regarding repayment. They can choose to make partial payments, repay the loan in full, or make no payments at all. While there is no mandatory repayment schedule, repaying the loan is generally advisable. Payments can be made periodically or as a lump sum, depending on the policyholder’s financial situation.

Repaying the loan restores the cash value and the death benefit to their full potential, effectively freeing up the collateral and ensuring the policy’s intended benefit is preserved. Therefore, maintaining awareness of the loan balance and accrued interest is important for preserving the policy’s long-term value and benefits.