What Kind of Life Insurance Can You Borrow From?
Explore life insurance policies that allow you to borrow from their accumulated value. Understand the loan process and vital considerations.
Life insurance policies offer a death benefit to beneficiaries. Certain types also accumulate a “cash value” component. This cash value is a living benefit accessible during the policyholder’s lifetime. It represents a portion of premiums that grows over time, often tax-deferred.
Cash value accumulation creates an accessible fund within the policy. Policyholders can use this fund for various financial needs. Borrowing from a life insurance policy depends on this cash value. This distinguishes permanent life insurance from term policies, which lack cash value.
Types of Life Insurance with Borrowing Capability
Only permanent life insurance policies accumulate cash value, forming the basis for borrowing. A portion of each premium is allocated to this cash value, allowing it to grow. Growth mechanisms vary by policy type.
Whole life insurance is a traditional permanent coverage with guaranteed cash value growth. Premiums are fixed, and a predictable portion contributes to cash value, growing at a guaranteed interest rate. This predictable growth makes whole life a stable option for cash value accumulation and loans. Cash value is guaranteed to increase annually, regardless of market performance.
Universal life insurance offers more flexibility. Policyholders can adjust premiums and death benefits within limits. Cash value grows based on an insurer-declared interest rate, which can fluctuate but often has a minimum guaranteed rate. This flexibility allows faster accumulation with higher contributions but makes it sensitive to interest rate changes or premium schedules.
Variable universal life insurance allows policyholders to invest cash value in sub-accounts, similar to mutual funds. Cash value growth is tied to investment performance. This offers potential for higher returns and faster accumulation but carries market risk; cash value can decrease if investments perform poorly. Investment risk means cash value is not guaranteed and can fluctuate significantly.
How Policy Loans Work
Borrowing from a life insurance policy’s cash value differs from a traditional bank loan. It’s an advance against the policy’s cash value, with the policy serving as collateral. The insurer does not require a credit check, and approval is straightforward if sufficient cash value has accumulated.
Interest accrues on the outstanding loan balance, typically 5% to 8%, and can be fixed or variable. This interest generally compounds on the outstanding balance if not paid. Policyholders have flexibility in repayment, including making interest-only payments or deferring repayment indefinitely.
An outstanding policy loan reduces the death benefit. If the insured passes away with an unpaid loan, the loan amount plus accrued interest is deducted from the death benefit. Beneficiaries receive a lower payout. The policy’s cash value secures the loan, ensuring insurer recovery.
The loan uses cash value as security; it does not technically remove funds. Cash value continues to grow, potentially earning returns, even with a loan outstanding. However, the accessible cash value is reduced by the loan amount.
Important Considerations Before Borrowing
Before taking a loan against a life insurance policy, understand its implications. Interest accrues on the outstanding loan balance, increasing the total owed. If not paid, it can be added to the principal, causing the loan to grow.
An unpaid loan directly impacts the death benefit. The outstanding loan amount, including accrued interest, is subtracted from the death benefit paid to beneficiaries. This reduction can significantly diminish financial support for loved ones.
A substantial outstanding loan risks policy lapse. If the loan balance, including accrued interest, exceeds the policy’s cash value, the policy can lapse. This terminates coverage and can trigger immediate tax consequences.
Policy loans are generally tax-free, considered a loan, not a withdrawal. However, if the policy lapses with an outstanding loan, the loan amount (to the extent it exceeds premiums paid) can become taxable income. The IRS may view this as a taxable distribution, as outlined under Internal Revenue Code Section 7702.
Alternatives to borrowing exist for accessing cash value. Policyholders can make withdrawals, generally tax-free up to premiums paid, but these permanently reduce cash value and death benefit. Another option is surrendering the policy, terminating coverage and receiving the net cash surrender value. Surrendering ends the death benefit and may result in taxable income if cash value exceeds premiums paid.
How Policy Loans Work
Borrowing against a life insurance policy’s cash value differs from a traditional loan. It’s an advance using the policy’s cash value as collateral. No credit check is required, and approval is guaranteed if sufficient cash value is available.
Interest accrues on the outstanding loan balance, typically 5% to 8%, and can be fixed or variable. This interest generally compounds annually, increasing the total loan amount if left unpaid. Policyholders have flexibility in repayment, including interest-only payments or deferring repayment.
An outstanding policy loan directly reduces the death benefit. If the insured passes away with an unpaid loan, the total loan amount, including accrued interest, is subtracted. This ensures insurer recovery, but means beneficiaries receive a diminished payout, potentially impacting their financial security.
The policy’s cash value serves as the sole collateral, eliminating the need for external assets. Even with a loan outstanding, the policy remains in force, and its cash value continues to grow. This allows access to liquidity without surrendering the policy or disrupting its long-term growth potential, provided the loan balance does not exceed the cash value.
Important Considerations Before Borrowing
Before utilizing a life insurance policy loan, understanding its implications is paramount. Interest continuously accrues, and if not paid, it is added to the principal, causing the loan to increase. This compounding effect can lead to a significantly larger outstanding debt.
An unpaid loan directly reduces the death benefit. The full outstanding loan, including all accumulated interest, is subtracted from the policy’s face value. This can substantially decrease financial protection for surviving family members, potentially undermining estate planning objectives.
A major risk is policy lapse. If the outstanding loan balance, including accrued interest, exceeds the policy’s available cash value, the insurer may terminate the policy. This ends coverage and can trigger adverse tax consequences.
Policy loans are generally not taxable income when taken. However, if the policy lapses due to an outstanding loan, the loan amount may become taxable to the extent it exceeds premiums paid. This taxation applies to the “gain” in the policy, meaning accumulated cash value less premiums paid, as defined under Internal Revenue Code Section 7702.
Other methods exist for accessing a policy’s cash value. Policyholders can make direct withdrawals, generally tax-free up to premiums paid, but these permanently reduce cash value and death benefit. Alternatively, surrendering the policy cancels coverage to receive the cash surrender value, which may also result in taxable income if it exceeds total premiums paid.