What Life Insurance Can You Take a Loan From?

Life insurance policies can offer more than just a death benefit for beneficiaries; certain types also provide a living benefit through an accumulated cash value. This unique feature allows policyholders to access funds during their lifetime, including the option to take a loan. Understanding how this process works can provide financial flexibility when unexpected needs arise. Accessing these funds requires an understanding of the policy structure and the implications of borrowing against its value.

Life Insurance Policies with Cash Value

A “cash value” component is a distinct feature found in certain permanent life insurance policies. As premiums are paid, a portion contributes to this cash value, which grows over time on a tax-deferred basis. This accumulation differentiates these policies from term life insurance, which provides coverage for a specific period without building any cash value. Term life insurance is often considered “pure insurance” because its primary purpose is to offer a death benefit if the insured passes away within the policy’s term, and it does not have a savings or investment component.

Whole life insurance is a common type of permanent policy that builds cash value with guaranteed growth. Premiums for whole life policies typically remain fixed throughout the policy’s duration, and the cash value grows at a guaranteed interest rate set by the insurer. This predictable growth makes whole life a stable option for those seeking consistent cash value accumulation.

Universal life insurance represents another category of permanent life insurance that accumulates cash value, offering more flexibility than whole life. Policyholders may adjust premium payments and death benefits within certain limits. The cash value in universal life policies typically grows based on current interest rates, often with a guaranteed minimum rate. This flexibility allows for potential higher cash value growth, but it may also carry more risk depending on the policy’s design.

Taking a Loan from Your Policy

Obtaining a loan from a life insurance policy with cash value is a process distinct from traditional bank loans. The loan is not issued by a bank or third-party lender; instead, it is provided by the insurance company itself, using the policy’s accumulated cash value as collateral. This means there are generally no credit checks, income verification, or lengthy approval processes involved, making it a relatively straightforward way to access funds. Policyholders typically initiate a loan request by contacting their insurer and submitting a formal application, and funds can often be disbursed within a few business days.

The amount available for a loan is directly tied to the policy’s cash surrender value, which is the cash value minus any applicable surrender charges. Insurers commonly allow policyholders to borrow up to 90% or 95% of the accumulated cash value. While the loan uses the cash value as collateral, the cash value itself generally continues to grow within the policy, though its growth rate might be affected by the outstanding loan.

Policy loans accrue interest, which can be either fixed or variable, depending on the policy’s terms. Typical interest rates for these loans often range between 5% and 8%, which can be competitive compared to some personal loans. The interest is charged on the outstanding loan balance and is generally not tax-deductible.

A significant advantage of life insurance policy loans is their tax treatment. The loan amount received is generally not considered taxable income, as it is viewed as a debt against the policy rather than a distribution of gains. This tax-free status holds true as long as the policy remains in force. However, if the policy lapses or is surrendered while a loan is outstanding, any amount borrowed that exceeds the premiums paid into the policy could become taxable income.

Repaying and Managing Policy Loans

Managing a life insurance policy loan differs significantly from managing a conventional loan because there is typically no mandatory repayment schedule. Policyholders have the flexibility to repay the loan at their convenience, whether through a lump sum, periodic payments, or by choosing not to repay it during their lifetime. This flexibility can be a benefit, but it also carries important implications for the policy.

Interest continues to accrue on the outstanding loan balance, and if this interest is not paid, it can be added to the principal of the loan. If the total loan balance, including accrued interest, grows to exceed the policy’s cash value, the policy can lapse. A policy lapse means the coverage terminates, and the policyholder loses the life insurance protection. In such a scenario, any outstanding loan amount that exceeds the premiums paid could become taxable income.

An outstanding loan also directly reduces the death benefit paid to beneficiaries. If the policyholder passes away before the loan is fully repaid, the outstanding loan balance, along with any accrued interest, is deducted from the death benefit amount. This means beneficiaries will receive a reduced payout. For example, if a policy has a $500,000 death benefit and a $50,000 outstanding loan, beneficiaries would receive $450,000.

The presence of an outstanding loan can also affect the policy’s future cash value growth and potential dividend payments. While the cash value generally remains in the policy and may continue to earn interest or dividends, the loan amount reduces the available cash value that can generate further growth or dividends. This reduction can slow the overall accumulation of cash value within the policy. Understanding their long-term impact on the policy’s health and the eventual death benefit is important for effective financial planning.