What Life Insurance Policies Can You Borrow From?

Life insurance provides a financial safeguard for loved ones, offering a death benefit upon the insured’s passing. Some policies are designed purely for this protection, while others allow for the accumulation of value over time. This accumulated value can be accessed by the policyholder during their lifetime. The ability to access this value depends on the policy’s structure and whether it includes a savings component.

Understanding Cash Value Life Insurance

Cash value life insurance is a type of permanent life insurance that combines a death benefit with a savings or investment feature. A portion of each premium payment is allocated to a separate account within the policy, accumulating value over time. This component is distinct from the death benefit and can be accessed by the policyholder during their lifetime.

Cash value grows on a tax-deferred basis, meaning earnings are not taxed until withdrawn or the policy is surrendered. The accumulation rate varies by policy type and insurer’s performance or guarantees. This accumulated cash value can be leveraged for various purposes, including policy loans.

It takes several years for cash value to build, as initial premiums often cover policy costs and fees. As payments continue and returns accrue, the cash value can grow considerably. This growth provides the foundation for borrowing, as the accumulated cash value serves as collateral for any policy loans.

Policies That Allow Borrowing

Term life insurance policies, designed for a specific duration, do not include a cash value component and therefore do not allow for borrowing. The primary types of permanent policies that offer this feature are Whole Life, Universal Life, and Variable Universal Life.

Whole Life insurance provides a guaranteed death benefit and fixed, level premium payments. Its cash value grows at a guaranteed rate, offering predictable accumulation. This stable growth makes it a reliable source for policy loans once sufficient cash value has accrued.

Universal Life (UL) insurance offers more flexibility than Whole Life, allowing premium and death benefit adjustments within limits. Its cash value typically grows based on current interest rates, often with a guaranteed minimum. This flexibility can impact cash value accumulation, affecting the amount available for loans.

Variable Universal Life (VUL) insurance provides flexibility and an investment component. Its cash value is invested in subaccounts chosen by the policyholder. Cash value growth, and thus the amount available for loans, fluctuates with the performance of these investments, introducing higher risk and potential for greater returns.

How Policy Loans Work

Policyholders borrow from the insurance company, with the policy’s cash value serving as collateral, which differs from traditional loans and direct withdrawals. This means the cash value typically continues to earn interest or investment returns, even while a loan is outstanding.

Obtaining a policy loan is straightforward, requiring no credit checks. Policyholders submit a request to their insurer, and if sufficient cash value has accumulated, funds are disbursed within a few business days. Most insurers allow borrowing up to 90% of the policy’s accumulated cash surrender value.

Policy loans generally accrue interest, charged by the insurance company, with rates typically ranging from 5% to 8%. These rates can be lower than those for personal loans or credit cards. Repayment is flexible, with no fixed schedule; policyholders can repay at their own pace, or not at all during their lifetime.

If the loan is not repaid, the outstanding balance, including accrued interest, will be deducted from the death benefit paid to beneficiaries, reducing the financial protection received. Continued interest accrual on an unpaid loan can also diminish the policy’s cash value over time, impacting its financial strength.

Important Considerations for Policy Loans

While policy loans offer flexibility, several factors warrant careful consideration. An outstanding loan, particularly if interest is not consistently paid, can jeopardize the policy’s long-term viability. If the accumulated loan balance, including accrued interest, exceeds the policy’s cash value, the policy can lapse. A policy lapse means coverage terminates, and the policyholder loses their life insurance protection.

Tax implications are also important. Generally, policy loans are not considered taxable income as long as the policy remains in force and the loan amount does not exceed the premiums paid. However, if a policy lapses or is surrendered with an outstanding loan, the loan amount exceeding premiums paid can become taxable income. This can result in a “phantom income” tax liability, where taxes are owed on income not directly received.

An exception to the tax-free nature of policy loans arises if the policy is classified as a Modified Endowment Contract (MEC). A policy becomes an MEC if it is overfunded, typically by exceeding certain IRS premium limits within its first seven years. Loans from an MEC are taxed differently, with gains considered taxable income first, and a potential 10% penalty if the policyholder is under age 59½.

The death benefit will be reduced by any outstanding loan balance and accrued interest at the time of the insured’s death. This reduction can impact the financial support intended for beneficiaries. Policyholders should understand this trade-off, as borrowing against the policy’s cash value pre-accesses a portion of the future death benefit.

Policyholders should also evaluate the trade-off between the loan interest rate and their cash value growth rate. While policy loan rates can be competitive, the interest charged may offset or exceed cash value growth, potentially slowing accumulation. Other ways to access cash include withdrawals or surrendering the policy, but these typically reduce cash value directly or terminate coverage, making loans a preferred option for those who wish to maintain their policy.