What Life Insurance Policies Can You Borrow From?

Life insurance policies offer various benefits, including providing a financial safety net for beneficiaries. Beyond the death benefit, certain policies accumulate cash value that policyholders can access during their lifetime. This accumulated value can serve as a source of funds through policy loans. Understanding how these loans function and which policies offer this feature is important for those considering this option.

Types of Life Insurance Policies

Life insurance policies are broadly categorized into term life and permanent life insurance, with only permanent policies building cash value that can be borrowed against. Term life insurance provides coverage for a specific period, such as 10, 20, or 30 years, and typically does not accumulate cash value. It focuses solely on providing a death benefit if the insured passes away within the specified term.

Permanent life insurance, conversely, remains in force for the policyholder’s entire life, provided premiums are paid. These policies have a cash value component that grows over time on a tax-deferred basis. Two primary types of permanent life insurance that allow borrowing are Whole Life and Universal Life insurance.

Whole Life insurance offers guaranteed cash value growth and a fixed premium. A portion of each premium payment is allocated to the cash value, which accumulates at a guaranteed interest rate.

Universal Life (UL) insurance provides more flexibility regarding premiums and death benefits. Its cash value growth can vary, depending on the specific type of Universal Life policy. Some UL policies may offer interest rates that fluctuate with market conditions, while others might have a fixed rate or be tied to an index.

Understanding Policy Loans

A policy loan involves borrowing money from the insurer, using the policy’s accumulated cash value as collateral. This is not a withdrawal of the cash value itself, but rather a loan against it, meaning the cash value remains within the policy. Insurers typically allow policyholders to borrow up to 90% of the policy’s cash value.

These loans come with an interest rate, which can be either fixed or variable, typically ranging from 5% to 8%. The interest accrues on the outstanding loan balance. Unlike traditional bank loans, there is no set repayment schedule, offering policyholders flexibility in how and when they repay the borrowed funds.

While the cash value serves as collateral, the portion of the cash value equivalent to the loan amount may not continue to grow or earn interest at the same rate as the unencumbered portion. This can impact the overall growth potential of the policy’s cash value. The application process for a policy loan is straightforward and does not involve a credit check.

An outstanding loan, including any accrued interest, reduces the death benefit paid to beneficiaries if the loan is not fully repaid before the insured’s passing. For instance, if a policy has a $500,000 death benefit and an outstanding loan of $50,000, beneficiaries would receive $450,000.

Important Considerations for Policy Loans

Policy loans generally offer tax advantages, as the loan proceeds are typically not considered taxable income. This tax-free status holds true unless the policy lapses or is surrendered with an outstanding loan balance that exceeds the policy’s cost basis. The cost basis refers to the total premiums paid into the policy, less any prior tax-free distributions.

A risk associated with policy loans is the potential for policy lapse. If the outstanding loan balance, combined with accrued interest, grows to exceed the policy’s cash value, the policy can terminate. Such a lapse can trigger a taxable event, where the portion of the loan that exceeded the cost basis becomes taxable income.

Policyholders should continue paying their regular premiums, even when a loan is outstanding, to keep the policy in force. Failure to pay premiums can exacerbate the risk of the loan balance surpassing the cash value.

Policy loans differ from policy withdrawals or surrenders in their impact. A withdrawal directly removes a portion of the cash value, which permanently reduces the death benefit and cash value. A surrender involves canceling the entire policy to receive its cash surrender value, terminating all coverage. Loans, however, allow continued coverage while providing access to funds.