What Life Insurance Policy Can You Borrow Against?

Life insurance policies provide funds to beneficiaries upon the insured’s passing. Certain types of policies also accumulate a cash value, which policyholders can access through a loan during their lifetime. Not all policies offer this feature, as the ability to borrow is linked to the presence and growth of this cash value.

Policies with Borrowing Capabilities

The ability to borrow against a life insurance policy depends on its design to accumulate cash value. Permanent life insurance policies, such as whole life and universal life, build this savings component over time. A portion of each premium payment goes to the cash value, which grows tax-deferred through guaranteed interest rates, potential dividends, or market-linked returns.

Whole life insurance offers guaranteed cash value accumulation, with predictable growth and fixed premiums. A portion of each payment contributes to the cash value, earning interest at a set rate. Universal life insurance provides more flexibility in premium payments and death benefits, with cash value growth often tied to current interest rates or market indexes, usually with a guaranteed minimum rate. Both policy types allow policyholders to access this accumulated cash value.

Term life insurance policies are designed for temporary coverage and do not build cash value. As a result, they do not offer borrowing capabilities. Premiums for term life primarily cover the death benefit cost for a specific period, without contributing to a savings component. Policyholders seeking to borrow from their life insurance must select a permanent policy with a cash value component.

How Policy Loans Work

A life insurance policy loan involves borrowing from the insurer using the policy’s cash value as collateral, rather than directly withdrawing funds. The policy remains in force, and the cash value continues to grow, potentially earning interest or dividends, even with an outstanding loan. Policy loans generally do not require a credit check or a lengthy approval process, as the loan is secured by the policy’s own value.

The amount available for a loan is typically a percentage of the accumulated cash value, often up to 90% or 95%. Interest accrues on the loan balance, with rates commonly ranging from 5% to 8%, which can be fixed or variable depending on policy terms. Any outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries if the policyholder passes away before repayment.

Unlike conventional loans, policy loans usually do not have a fixed repayment schedule. This flexibility allows policyholders to repay the loan at their discretion, or choose not to repay it during their lifetime. The loan is an advance of the death benefit, and the policy’s cash value acts as the primary security. This mechanism provides funds without affecting external credit reports.

Managing and Repaying a Policy Loan

Managing a life insurance policy loan involves understanding its flexible repayment structure and the implications of non-repayment. Policyholders can repay the loan in full, make partial payments, or simply pay the accruing interest. Some choose to pay only the interest, allowing the principal balance to remain outstanding, or they may opt for no payments at all. This flexibility contrasts with the rigid repayment schedules of most traditional loans.

If the loan and its accrued interest are not repaid, the outstanding balance is deducted from the death benefit when the insured dies. This reduces the amount beneficiaries will receive. Allowing interest to compound can significantly increase the loan balance over time, further eroding the death benefit.

A risk of an unpaid loan is the potential for the policy to lapse. If the loan balance, including accumulated interest, grows to exceed the policy’s available cash value, the insurance company may terminate the policy. This means the policyholder loses coverage, and there could be adverse tax consequences. While repayment is flexible, it is prudent to monitor the loan balance to prevent policy lapse and ensure the policy’s long-term viability.

Factors to Consider Before Borrowing

Before taking a loan against a life insurance policy, policyholders should consider several factors. One primary consideration is the impact on beneficiaries. An outstanding loan reduces the death benefit paid to beneficiaries, which could undermine the policy’s original purpose. Policyholders should evaluate whether this reduction aligns with their financial planning goals for their loved ones.

Another important aspect is the policy’s long-term cash value growth. While the cash value typically continues to earn interest or dividends even with a loan, the loan itself accrues interest. If the loan’s interest rate is higher than the cash value’s growth rate, or if interest is not paid, the net growth of the cash value can be negatively affected. This can slow the accumulation of cash value, potentially impacting future access to funds or the policy’s overall financial strength.

There are potential tax implications if the policy lapses with an outstanding loan. The unpaid loan amount may be treated as taxable income to the extent it exceeds the premiums paid into the policy (cost basis). This can result in an unexpected tax bill. Policyholders should also review their specific policy’s terms, including interest rates and rules regarding loan amounts and repayment, as these can vary by insurer and policy type.