What Life Insurance Policies Can You Borrow From?

Life insurance policies offer financial protection for beneficiaries after the policyholder’s passing. Certain types of these policies also provide a unique financial feature: the ability to access accumulated cash value during the policyholder’s lifetime. This feature allows individuals to use their policy as a source of liquidity, providing a means to borrow funds for various needs. Understanding how these policies function and the implications of borrowing from them is important for anyone considering such a financial strategy.

Understanding Cash Value Life Insurance

Cash value life insurance represents a category of permanent life insurance policies that include a savings component, accumulating monetary value over time. Unlike term life insurance, which provides coverage for a specific period and typically does not build cash value, permanent policies remain in force for the policyholder’s entire life. This cash value grows separately from the death benefit and can be accessed by the policyholder.

Two primary types of cash value policies are Whole Life Insurance and Universal Life Insurance. Whole life policies typically feature fixed premiums and a guaranteed cash value growth rate, making their accumulation predictable. A portion of each premium payment contributes to the policy’s cash value, which grows on a tax-deferred basis, meaning taxes on the gains are postponed until the funds are withdrawn.

Universal life insurance policies offer more flexibility regarding premium payments and death benefits. Policyholders can often adjust their premium payments within certain limits, and the cash value growth may be tied to an interest rate set by the insurer or market performance. Like whole life, the cash value in universal life policies also grows on a tax-deferred basis. This accessible cash value serves as a living benefit, providing a resource that can be utilized for various purposes, including serving as collateral for a loan.

How Policy Loans Operate

A policy loan against a cash value life insurance policy functions as a loan from the insurance company, not a withdrawal of the cash value itself. The policyholder’s accumulated cash value serves as collateral for the loan, which means the policy remains intact and continues to provide coverage. This arrangement allows accessing liquidity without traditional credit checks or a lengthy approval process.

The unique aspect of these loans is that the policy’s cash value continues to grow and earn interest or dividends, even while a loan is outstanding, though the loan itself accrues interest. The interest rate for a policy loan can be either fixed or variable. Fixed rates offer predictable costs, while variable rates may adjust periodically based on market indices or rates set by the insurer.

Interest typically accrues on the outstanding loan balance. Policyholders have considerable flexibility regarding repayment, as there is often no strict repayment schedule. Individuals can pay back the loan at their own pace, make partial payments, or pay only the interest, letting the principal balance persist. Unpaid interest can be added to the outstanding loan balance, causing the total amount owed to increase over time.

Any outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries if the policyholder passes away before the loan is fully repaid. This reduction ensures the insurance company recovers the borrowed funds from the policy’s proceeds. The policyholder also retains ownership and control of the policy, unlike a direct withdrawal which would permanently reduce the cash value.

Financial Considerations of Policy Loans

An outstanding loan against a life insurance policy directly impacts the policy’s death benefit. If the policyholder passes away before the loan is fully repaid, the outstanding loan balance, including any accrued interest, will be deducted from the death benefit. This reduction means that while the loan provides immediate liquidity, it diminishes the financial protection intended for the beneficiaries.

Unpaid loan interest can increase the total loan balance, leading to an erosion of the policy’s cash value over time. If interest payments are not consistently made, the accrued interest is added to the principal loan amount, causing the loan to compound and grow.

If the outstanding loan balance, augmented by compounding interest, eventually surpasses the policy’s cash value, the policy faces a risk of lapsing. A policy lapse results in the termination of coverage, meaning the policyholder loses the death benefit and any remaining cash value.

Repaying the loan mitigates these financial risks and restores the policy’s integrity. As the loan balance is reduced, the policy’s cash value is replenished, and the full death benefit is reinstated for the beneficiaries. Some policies may feature a “wash loan,” where the interest rate charged on the loan is offset by the interest rate credited to the policy’s cash value used as collateral.

Tax Implications of Policy Loans

Policy loans are generally not considered taxable income when they are taken, as they are treated as a debt against the policy’s cash value, rather than a distribution of earnings. This allows policyholders to access liquidity without triggering an immediate tax event, offering an advantage compared to other forms of accessing policy value like withdrawals.

However, a policy loan can become taxable under specific circumstances. If a policy lapses or is surrendered while a loan is outstanding, the loan amount may become taxable to the extent it exceeds the policyholder’s “basis” in the contract. Basis generally refers to the total premiums paid into the policy.

Modified Endowment Contracts (MECs) are subject to different tax rules regarding policy loans. A life insurance policy becomes an MEC if premiums paid within the first seven years exceed a certain limit set by tax law. Once classified as an MEC, this status is permanent.

Loans from MECs are treated on a Last-In, First-Out (LIFO) basis for tax purposes. This means any amount borrowed is first considered to come from the policy’s earnings, which are then taxable. Additionally, if the policyholder is under age 59½, the taxable portion of an MEC loan may be subject to an additional 10% federal penalty tax.