What Life Insurance Policies Can You Borrow Against?

Life insurance policies offer more than a death benefit; certain types also provide a financial resource during the policyholder’s lifetime. This benefit comes from the “cash value” component, which accumulates over time within specific permanent life insurance policies. Policyholders can access this accumulated value through a loan, which functions differently from a loan obtained from a bank. These loans are against the policy’s own value, with the cash value serving as collateral, offering a way to access funds without traditional credit checks.

Policies That Allow Borrowing

The ability to borrow against a life insurance policy is exclusively tied to permanent life insurance policies, as these are designed to build cash value over time. Term life insurance, by contrast, does not accumulate cash value and therefore does not offer a borrowing feature. Several types of permanent policies provide this financial flexibility.

Whole life insurance is characterized by its guaranteed cash value growth and fixed premiums. A portion of each premium payment contributes to this cash value, which grows on a tax-deferred basis and is guaranteed to increase over the life of the policy. This steadily growing cash value becomes available for policy loans, providing a predictable source of funds.

Universal life insurance offers flexibility in premium payments and death benefits, with its cash value growth tied to an interest rate set by the insurer. Universal life policies also accumulate cash value that can be accessed through loans.

Variable universal life insurance combines features of universal life with investment opportunities. The cash value in these policies is invested in sub-accounts, similar to mutual funds, and its value fluctuates with the performance of these investments. Policyholders can still borrow against the accumulated cash value, although the amount available will depend on market performance.

Understanding Policy Cash Value

The concept of cash value is central to understanding how borrowing against a life insurance policy works. Cash value represents a savings component within a permanent life insurance policy that grows over time, separate from the death benefit. A portion of each premium payment is allocated to this cash value, which then earns interest or investment gains, often on a tax-deferred basis.

This accumulated cash value serves a dual purpose: it acts as a living benefit for the policyholder and provides collateral for policy loans. It can be accessed during the policyholder’s lifetime for various financial needs.

A policy loan uses the cash value as security, and the loan amount must typically be repaid with interest. In contrast, a withdrawal directly reduces the policy’s cash value and, consequently, the death benefit payable to beneficiaries, as withdrawals are not repaid. If a policy is surrendered, the policyholder receives the cash value, less any surrender charges or outstanding loans.

The Policy Loan Process

Obtaining a loan from a life insurance policy is generally a straightforward process. Policyholders typically initiate the process by submitting a request to their insurance provider, specifying the desired loan amount, up to the available cash value.

Approval is not contingent on the policyholder’s credit history or financial standing. Since the loan is backed by the policy’s cash value, the insurer does not need to assess creditworthiness. The cash value serves as collateral, mitigating risk for the insurance company.

The maximum loan amount available is typically limited to the accumulated cash value within the policy, minus any existing outstanding loans or liens. Interest is charged on policy loans, and the rates can vary, often being fixed or variable depending on the policy terms.

Policy loans offer flexibility in repayment. Unlike traditional loans that come with strict monthly payment schedules, policy loans often have no fixed repayment terms. While interest continues to accrue on the outstanding balance, policyholders can choose to repay the loan at their convenience, make partial payments, or even defer repayment indefinitely, as long as the policy remains in force.

Implications of Unpaid Policy Loans

Leaving a policy loan unpaid has consequences. The most immediate implication is a reduction in the death benefit paid to beneficiaries. Any outstanding loan balance, along with accrued interest, is directly subtracted from the death benefit upon the insured’s passing. This means beneficiaries will receive a lower payout than the policy’s face amount.

A more severe risk arises if the outstanding loan balance, including accumulated interest, grows to exceed the policy’s cash value. In such a scenario, the policy can lapse, meaning it terminates due to insufficient funds to cover its costs.

When a policy lapses with an outstanding loan, particularly if the policy has gained value, the portion of the loan that exceeds the premiums paid into the policy may become taxable income to the policyholder. This tax implication is especially relevant if the policy has been classified as a Modified Endowment Contract (MEC) by the Internal Revenue Service (IRS). MECs have specific tax rules, and loans or withdrawals from them are generally taxed as income first, up to the policy’s gain, and may also be subject to a 10% penalty if the policyholder is under age 59½.

Interest continues to accrue on the outstanding loan until it is fully repaid or the policy terminates. This ongoing interest can significantly increase the total amount owed, further reducing the policy’s value and increasing the risk of lapse.