What Type of Insurance Can You Borrow From?

Life insurance policies primarily offer a death benefit to beneficiaries, but certain types also accumulate a cash value component. This cash value can become a financial resource accessible to the policyholder during their lifetime. Unlike term life insurance, which provides coverage for a specific period and does not build cash value, permanent life insurance policies offer lifelong coverage and develop this accessible fund. Accessing these funds provides financial flexibility, allowing policyholders to address various needs without liquidating other assets.

Types of Insurance with Cash Value

Several types of permanent life insurance policies are designed to accumulate a cash value, which can then be accessed by the policyholder. These policies blend a death benefit with a savings or investment component, distinguishing them from temporary coverage options.

Whole life insurance represents a traditional form of permanent coverage, characterized by guaranteed premiums, a guaranteed death benefit, and a guaranteed rate of cash value growth. The cash value grows on a tax-deferred basis, steadily increasing over the policy’s lifetime. This predictable growth provides a reliable fund that policyholders can access through loans or withdrawals.

Universal life (UL) insurance offers more flexibility compared to whole life policies, allowing policyholders to adjust premium payments and death benefits within certain limits. The cash value grows based on an interest rate set by the insurer, which may fluctuate but often comes with a guaranteed minimum rate. This flexibility allows for adjusted premium payments, potentially accelerating cash value growth. Policyholders can also reduce payments if the cash value is sufficient to cover policy costs.

Variable universal life (VUL) insurance policies provide greater flexibility and potential for cash value growth, though with increased risk. In a VUL policy, the cash value is invested in various sub-accounts, similar to mutual funds, chosen by the policyholder. Cash value growth is directly tied to the performance of these investments, meaning it can grow significantly during favorable market conditions but also decrease with poor performance. This investment-linked cash value serves as a source for loans and withdrawals, but its value fluctuates, requiring policyholders to monitor their investment choices.

How Policy Loans Work

Borrowing from a life insurance policy’s cash value operates distinctly from conventional loans obtained from banks or other financial institutions. A policy loan is not extended from the insurer’s general funds; instead, the policyholder is essentially borrowing their own money, with the policy’s accumulated cash value serving as collateral. This arrangement allows the policy to remain in force while the policyholder accesses funds.

The process of taking out a policy loan typically involves the policyholder requesting a specific amount, usually up to a certain percentage of the policy’s cash surrender value. Insurers commonly allow loans up to 90% or 95% of the available cash value, though this percentage can vary by policy and insurer. No formal credit check is required for a policy loan, as the loan is secured by the policy’s cash value itself.

Interest is charged on the outstanding loan balance, and this interest generally accrues whether or not the policyholder makes repayments. The interest rate on policy loans can be fixed or variable, often ranging from 5% to 8%. Unlike traditional loans with fixed repayment schedules, policy loans offer significant repayment flexibility; the policyholder can repay the loan at their own pace, or even choose not to repay it at all. However, any unpaid interest will be added to the loan principal, leading to compound interest.

An outstanding policy loan, including any accrued and unpaid interest, directly reduces the death benefit paid to beneficiaries upon the insured’s passing. For example, if a policy has a $500,000 death benefit and an outstanding loan of $50,000, the beneficiaries would receive $450,000. Policyholders should understand this impact, as it can diminish the financial protection for their loved ones.

A substantial 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. This typically occurs if no loan repayments are made and the cash value growth does not outpace the accumulating loan interest. A policy lapse can have severe consequences, including the loss of coverage and potential tax liabilities.

From a tax perspective, policy loans are generally considered tax-free, as they are viewed as an advance of the policyholder’s own funds, not as taxable income. This tax-advantaged status holds true as long as the policy remains in force. However, if the policy lapses or is surrendered with an outstanding loan balance, the amount of the loan that exceeds the policyholder’s cost basis (total premiums paid) could become taxable income. This is because the IRS may then view the loan as a distribution from the policy.

Accessing Your Cash Value

Beyond policy loans, there are other distinct methods for policyholders to access the accumulated cash value within their permanent life insurance policies. These methods, while offering access to funds, have different implications for the policy’s future and its tax treatment compared to loans.

One method is through withdrawals, also known as partial surrenders, where money is directly taken out of the cash value. This process permanently reduces the policy’s cash value and often results in a corresponding reduction in the death benefit. Withdrawals are generally tax-free up to the amount of premiums paid into the policy, which is considered the policyholder’s cost basis. Any amount withdrawn that exceeds the cost basis may be subject to ordinary income tax.

Alternatively, a policyholder can choose to perform a full surrender of the policy. This action terminates the entire insurance contract, and the policyholder receives the cash surrender value. The cash surrender value is typically the accumulated cash value less any surrender charges imposed by the insurer and any outstanding policy loans. Any amount received from the surrender that exceeds the total premiums paid into the policy (cost basis) is considered taxable income and is subject to ordinary income tax.

It is important to distinguish these access methods from policy loans. While policy loans allow the policy to remain in force, provided the loan does not cause a lapse, withdrawals and full surrenders represent a permanent reduction or termination of the policy. Withdrawals reduce the cash value and death benefit, while a full surrender ends the coverage entirely. Therefore, policyholders must carefully consider their long-term insurance needs and financial goals before choosing between these methods of accessing cash value.