What Type of Life Insurance Can You Borrow Against?

Life insurance primarily provides financial protection for beneficiaries after the policyholder’s passing, delivering a tax-free death benefit. Certain types of life insurance policies also offer a unique feature: the ability to accumulate cash value. This cash value can serve as a living benefit, providing access to funds during the policyholder’s lifetime. Understanding which policies offer this feature and how it can be accessed is important.

Life Insurance Policies with Cash Value

Cash value in a life insurance policy represents a savings component that grows over time, separate from the policy’s death benefit. A portion of each premium payment contributes to this cash value, which then earns interest on a tax-deferred basis, meaning taxes on the growth are not due as long as the funds remain within the policy. This cash value can be accessed by the policyholder through various methods, including loans or withdrawals.

Whole life insurance is a type of permanent life insurance that builds cash value. These policies feature guaranteed cash value growth, fixed premium payments, and lifelong coverage. The cash value grows at a fixed interest rate, offering predictability and stability. This guaranteed growth makes whole life a reliable option for accumulating accessible funds.

Universal life insurance, another permanent coverage, also accumulates cash value, but with more flexibility. Its cash value growth is tied to interest rates, though a guaranteed minimum rate is typically in place. Universal life policies allow for adjustments to premium payments and death benefits, providing adaptability as financial circumstances change. Variations like Indexed Universal Life (IUL) and Variable Universal Life (VUL) link cash value growth to market indices or investment performance, offering potential for higher returns but carrying more risk.

In contrast, term life insurance does not build cash value. Term policies provide coverage for a specific period, such as 10, 20, or 30 years, and typically have lower premiums compared to cash value policies. Since there is no savings component, term life insurance cannot be borrowed against. Only policies with a cash value component, like whole life and universal life, are eligible for policy loans.

Understanding Policy Loans

Borrowing against a life insurance policy’s cash value involves taking a loan directly from the insurer, using the cash value as collateral. This is not a withdrawal of the cash value itself; rather, the cash value continues to grow within the policy, even while a loan is outstanding. Insurers typically allow policyholders to borrow up to 90% or 95% of the cash value.

Interest is charged on these policy loans, with rates often ranging between 5% and 8%, which can be fixed or variable depending on the policy terms. The loan funds come from the insurance company’s general account, not directly from the policyholder’s cash value. This structure allows the cash value to theoretically continue earning interest or dividends, though an outstanding loan may affect dividends credited in some policies.

A significant aspect of a policy loan is its impact on the death benefit. Any outstanding loan balance, along with accrued interest, will reduce the death benefit paid to beneficiaries if the insured passes away before the loan is fully repaid. The policy remains in force as long as premiums are paid and the loan does not exceed the cash value.

Policy loans are generally not considered taxable income as long as the policy remains active and is not surrendered or allowed to lapse. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount exceeding the policy’s “basis” (total premiums paid minus any tax-free distributions) can become taxable income. This potential tax consequence is an important consideration when accessing cash value through a loan, especially if the policy might terminate prematurely.

Managing Your Policy Loan

Repaying a life insurance policy loan offers considerable flexibility, as there is typically no fixed repayment schedule. Policyholders are not usually required to make regular payments. However, interest continues to accrue on the outstanding loan balance, which can lead to the loan amount growing over time if not managed.

Policyholders have several options for managing their loan, including making a lump-sum repayment, establishing periodic payments, or allowing the interest to be added to the loan balance. While this flexibility is a benefit, allowing the loan balance to grow unchecked carries implications for the policy. Unpaid interest can reduce the cash value, and if the total loan amount, including accrued interest, exceeds the policy’s cash value, the policy could lapse.

A policy lapse due to an outstanding loan can have significant consequences. If a policy terminates because the loan balance plus interest surpasses the cash value, the policyholder loses coverage. This event can also trigger a taxable outcome, where the outstanding loan amount exceeding the policy’s basis may be taxable income. This “phantom income” can result in an unexpected tax bill, even if no cash was received. Understanding the specific terms and conditions provided by the insurer is important to avoid unintended policy termination or adverse tax implications.