What Type of Life Insurance Can You Borrow From?

Life insurance serves as a foundational component of many financial plans, offering a layer of protection for beneficiaries. Beyond its primary role of providing a death benefit, certain types of life insurance policies possess a unique feature: the ability to access funds during the policyholder’s lifetime. This liquidity can be a valuable resource, providing financial flexibility for various needs. Understanding which policies offer this option and how it functions is important for individuals seeking to maximize the utility of their life insurance coverage.

Policies That Allow Borrowing

The fundamental concept enabling borrowing from a life insurance policy is its cash value component. Cash value is a living benefit, distinct from the death benefit, which accumulates within certain types of policies over time.

Only permanent life insurance policies, such as whole life and universal life, build cash value, making them eligible for policy loans. Term life insurance policies do not accumulate cash value and therefore do not offer a borrowing feature. A portion of each premium payment made on a permanent policy is allocated to the cash value component, which then grows on a tax-deferred basis. It typically takes several years for sufficient cash value to build within a policy before it becomes available for loans.

How Policy Loans Work

Obtaining a loan against a life insurance policy’s cash value involves a straightforward process, as the policy itself serves as collateral. Unlike traditional loans, these loans do not require a credit check or extensive approval processes, making them accessible to policyholders with sufficient cash value. The loan amount is usually limited to a percentage of the policy’s cash value, often up to 90%.

Interest accrues on the policy loan, with rates typically ranging between 5% and 8%. While there is no mandatory repayment schedule, interest continues to compound on the unpaid balance. Policyholders have flexibility in repayment, including making regular payments, interest-only payments, or no payments at all. However, an outstanding loan, including accrued interest, will reduce the death benefit paid to beneficiaries.

If the loan balance and accrued interest grow to exceed the policy’s cash value, the policy may lapse, potentially leading to a loss of coverage and adverse tax consequences.

Types of Policies Supporting Loans

Several types of permanent life insurance policies accumulate cash value, thus enabling policy loans. Whole life insurance offers a guaranteed cash value growth rate and fixed premiums. Its cash value component grows predictably over time, providing a stable source for potential loans.

Universal life (UL) insurance provides more flexibility in premiums and death benefits, with its cash value growth tied to current interest rates. This flexibility allows policyholders to adjust payments, and the cash value can be used to cover premiums if needed.

Variable universal life (VUL) insurance offers investment options for the cash value, allowing policyholders to choose sub-accounts that invest in stocks, bonds, or other securities. The cash value growth in VUL policies is not guaranteed and fluctuates with market performance, offering potential for higher returns but also greater risk.

Indexed universal life (IUL) insurance links its cash value growth to the performance of a stock market index without directly investing in the market. IUL policies typically include a floor, protecting against market losses, and a cap, limiting potential gains, balancing growth potential with downside protection.

Key Aspects of Policy Loans

Policy loans generally offer favorable tax treatment, as the borrowed funds are typically not considered taxable income. This tax-free status holds as long as the policy remains in force and the loan amount does not exceed the premiums paid. However, if the policy lapses or is surrendered with an outstanding loan balance that exceeds the premiums paid, the difference may become taxable income.

A significant consequence of taking a policy loan is its impact on the death benefit. Any outstanding loan balance, along with accrued interest, will be deducted from the death benefit paid to beneficiaries upon the policyholder’s death. This reduction can diminish the financial protection intended for loved ones.

It is important to distinguish a policy loan from a cash value withdrawal. While a loan requires repayment and maintains the policy’s cash value as collateral, a withdrawal permanently removes funds from the policy, directly reducing both the cash value and the death benefit. Withdrawals may also have different tax implications, becoming taxable once they exceed the total premiums paid into the policy.