What Life Insurance Policies Can You Borrow From?

Life insurance policies offer financial protection for beneficiaries after the policyholder’s passing. Beyond this primary function, certain types of life insurance policies can also serve as a financial resource during the policyholder’s lifetime. This access to funds is typically facilitated through policy loans, which draw from the accumulated cash value within the policy. Understanding how these policies function and the mechanisms of such loans is important for anyone considering life insurance as a financial tool.

Policies That Allow Borrowing

The ability to borrow from a life insurance policy hinges on the presence of an accumulated cash value, a feature exclusive to permanent life insurance policies. A portion of each premium payment contributes to this cash value, which grows over time on a tax-deferred basis. This savings component is accessible during the policyholder’s lifetime. Term life insurance policies, conversely, do not build cash value and therefore do not offer a borrowing feature.

Whole life insurance is a type of permanent policy that offers guaranteed cash value growth. When premiums are paid, a portion is allocated to the cash value account, which grows at a fixed, predetermined interest rate. This predictable growth means the cash value is guaranteed to reach a specific amount by a certain age, at which point it equals the policy’s face value. Policyholders may also receive dividends if the policy is with a mutual insurance company, which can further enhance cash value growth if reinvested.

Universal life insurance policies also build cash value, but they offer more flexibility than whole life. The cash value growth in universal life is interest-sensitive, meaning it grows based on current interest rates set by the insurer, often with a guaranteed minimum rate. These policies allow for flexible premium payments, which can impact the rate of cash value accumulation. Policyholders can sometimes adjust their premiums or even use accumulated cash value to cover future premium payments.

Variable universal life (VUL) insurance provides a cash value component that is linked to investment performance. With VUL, policyholders can allocate their cash value into various subaccounts, which operate similarly to mutual funds, investing in stocks, bonds, or money market funds. This offers the potential for higher growth, but it also carries market risk. Despite the investment risk, the cash value growth within a VUL policy is generally tax-deferred.

Understanding Policy Loans

A loan from a life insurance policy is taken from the insurance company, with the policy’s cash value serving as collateral. The cash value generally continues to accumulate interest or investment gains even while a loan is outstanding.

The amount available for a loan is a percentage of the accumulated cash value, often up to 90%. There is no credit check required to obtain a policy loan because the cash value acts as security. This makes policy loans accessible without impacting one’s credit score.

Interest is charged on the loan. This interest typically accrues and can be compounded if not paid. While the interest rates are often lower than those for traditional personal loans, they are not tax-deductible for the policyholder in most cases.

Policy loans offer favorable tax treatment. They are not considered taxable income as long as the policy remains in force. The Internal Revenue Service (IRS) views these transactions as a loan against an asset, not as a withdrawal of income. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount, up to the policy’s gain (cash value minus premiums paid), can become taxable income. This liability arises because the loan is then treated as a distribution.

Obtaining a policy loan is a straightforward process. Policyholders typically contact their insurer and submit a request form. The funds can be disbursed within a few days, providing quick access to cash for various purposes without restrictions on how the money is used.

Loan Repayment and Policy Impact

Policy loans offer flexibility in repayment, unlike conventional bank loans. There is generally no fixed repayment schedule, allowing policyholders to repay the loan at their own pace or even choose not to repay it at all. However, interest continues to accrue on the outstanding loan balance.

An outstanding policy loan directly impacts the death benefit payable to beneficiaries. If the loan, including any accrued and unpaid interest, is not repaid before the policyholder’s death, the outstanding balance will be deducted from the death benefit.

The loan also affects the policy’s cash value. While the cash value continues to earn interest or investment returns, the loan amount is held as collateral, reducing the net cash value available for other uses, such as future withdrawals or additional loans. If unpaid interest is added to the loan balance, it can further erode the cash value.

A significant consequence arises if a policy lapses with an outstanding loan. If the total loan balance, including accrued interest, grows to exceed the policy’s cash value, the insurer may terminate the policy. Any untaxed gains in the policy, up to the amount of the outstanding loan, can become immediately taxable as ordinary income. This can result in an unexpected tax bill, even if the policyholder does not receive any cash at that time.

For policies that pay dividends, an outstanding loan might also affect dividend payments. Some insurers may reduce or adjust dividends on the portion of the cash value that is encumbered by the loan. This is because the portion used as collateral is not fully available to the policyholder for other purposes.