What Kind of Life Insurance Can You Borrow Against?

Life insurance policies offer financial protection for beneficiaries after the policyholder’s passing. Certain types also allow policyholders to access accumulated value during their lifetime by borrowing against their policy. Not all policies include this feature.

Identifying Policies for Borrowing

Only permanent life insurance policies accumulate cash value, which serves as the foundation for borrowing. This cash value grows on a tax-deferred basis as premiums are paid, with a portion allocated to earn interest or investment returns.

Whole life insurance is a permanent policy with fixed premiums and a guaranteed death benefit. Its cash value grows at a guaranteed rate, providing a predictable source for loans. This consistent growth makes whole life policies a reliable option for individuals seeking to borrow against their policy’s value.

Universal life insurance offers more flexibility in premium payments and death benefits. Its cash value accumulation is influenced by credited interest, which can fluctuate based on market conditions or insurer performance, often with a guaranteed minimum rate. This policy also allows borrowing against its cash value, providing adaptable access to funds.

Variable universal life insurance combines the premium flexibility of universal life with an investment component. Policyholders can allocate their cash value to various investment sub-accounts, such as stocks, bonds, or money market funds. While this offers the potential for higher cash value growth, it also carries investment risk, meaning the cash value can decrease. Borrowing is still possible, but the loan amount is based on the fluctuating cash value.

Term life insurance does not build cash value. It provides coverage for a specific period, such as 10, 20, or 30 years, and typically has lower premiums than permanent policies. Therefore, term life policies do not allow policyholders to borrow against them.

Understanding Life Insurance Loans

A life insurance policy loan differs from a traditional bank loan. Policyholders are not withdrawing money directly from their cash value. Instead, the cash value serves as collateral for a loan provided by the insurance company. The policy remains intact, and the cash value continues to grow, though the portion securing the loan may have different crediting rates.

The amount a policyholder can borrow is limited to a percentage of the accumulated cash value, often up to 90-95% of the policy’s surrender value. Any outstanding loans or charges reduce the available loan amount. The insurance company assesses an interest rate on the loan, which can be fixed or variable, generally ranging from 4% to 8% annually.

Repayment of a policy loan is flexible, with no mandatory schedule. Policyholders can repay the loan at their convenience, make partial payments, or not repay it during their lifetime. However, interest continues to accrue, increasing the total outstanding balance.

If the policyholder passes away with an outstanding loan, the loan amount plus any accrued interest is deducted from the death benefit paid to beneficiaries. This means beneficiaries will receive a reduced payout. The loan effectively acts as an advance on the death benefit.

Important Aspects of Policy Loans

An outstanding policy loan, along with its accrued interest, reduces the death benefit paid to beneficiaries. For example, if a policy has a $500,000 death benefit and a $50,000 outstanding loan with $2,000 in accrued interest, beneficiaries would receive $448,000. This reduction occurs regardless of when the loan was taken.

Policy loans carry a risk of policy lapse. If the outstanding loan balance, including accrued interest, grows to exceed the policy’s cash value, the policy may terminate. This can happen if premiums are not paid, or if interest accrues without repayment, eroding the cash value. Upon lapse, the outstanding loan amount may be considered taxable income if it exceeds the policyholder’s basis in the policy.

Generally, policy loans are tax-free transactions as long as the policy remains in force. This tax-advantaged status is a significant benefit, as policyholders can access funds without incurring immediate income tax liability. However, if the policy lapses or is surrendered with an outstanding loan where the loan amount exceeds the premiums paid into the policy (the cost basis), the excess amount could become taxable income.

Interest continues to accrue on the unpaid loan balance, even if no payments are made. This compounding interest can quickly increase the total amount owed, further reducing the available cash value and death benefit. The loan interest rate is applied to the entire outstanding balance, not just new borrowings.

Repaying the policy loan offers several benefits, including restoring the full death benefit for beneficiaries. It also allows the policy’s cash value to grow unencumbered. Regular payments, even if not strictly required, help maintain the policy’s financial integrity and maximize its long-term value.