What Type of Life Insurance Policy Can You Borrow Against?

Life insurance provides financial support to beneficiaries upon the policyholder’s death. While its primary purpose is a death benefit, certain policies also accumulate cash value from premiums paid. This cash value can be accessed by the policyholder, including through borrowing, offering both protection and liquidity.

Understanding Cash Value Life Insurance

Permanent life insurance policies accumulate cash value, offering coverage for the policyholder’s entire life. A portion of each premium contributes to this cash value, which grows over time. The way cash value builds and its flexibility varies among different permanent policy types.

Whole Life Insurance

Whole life insurance is a foundational type of permanent coverage. It features guaranteed cash value growth at a fixed interest rate, fixed premium payments, and a guaranteed death benefit. Consistent premiums contribute to a steadily increasing cash value, which may also be eligible for dividends. This predictability makes whole life a stable option for cash value accumulation.

Universal Life Insurance

Universal life insurance offers more flexibility than whole life policies. Policyholders can adjust premium payments and death benefit amounts. The cash value typically grows based on an insurer-set interest rate, often linked to market rates, usually with a guaranteed minimum. This design allows for potential cash value growth influenced by market performance, while still providing security.

Variable Universal Life Insurance

Variable universal life insurance introduces an investment-linked component to cash value growth. The cash value can be invested in various sub-accounts, similar to mutual funds, allowing policyholders to choose their investment strategy. This offers potential for greater returns if investments perform well, but also carries increased risk. Cash value can fluctuate with market performance, and poor performance could decrease both cash value and the death benefit.

The Mechanics of Policy Loans

Borrowing against a policy’s cash value differs from traditional bank loans. The accumulated cash value serves as collateral, securing the loan. This eliminates the need for a credit check, making funds accessible regardless of credit history. The loan is an advance from the insurer’s general account, with the cash value acting as a guarantee.

Interest accrues on the policy loan, typically paid back to the insurer. Rates are often competitive, sometimes ranging between 5% and 8%. The portion of cash value used as collateral may continue to earn interest or dividends within the policy. This means the underlying cash value can continue to grow even while a loan is outstanding.

Policy loans offer significant repayment flexibility. There is often no strict repayment schedule, allowing policyholders to repay the loan at their own pace, or not at all. Repayment options include periodic principal and interest payments, interest-only payments, or letting interest accrue and add to the loan balance. However, allowing interest to compound can increase the outstanding loan amount.

A policy loan is a temporary advance that must be repaid or will reduce the death benefit, allowing the cash value to continue growing. In contrast, a withdrawal permanently removes funds from the cash value, reducing both the cash value and the death benefit. Withdrawals can also be taxable if they exceed the premiums paid into the policy.

Important Aspects of Borrowing from Your Policy

An outstanding loan, if not repaid, will directly reduce the death benefit paid to beneficiaries. For example, if a policy has a $250,000 death benefit and a $50,000 outstanding loan, beneficiaries would receive $200,000. This reduction ensures the loan is settled from the policy proceeds.

A significant consideration is the potential for policy lapse. If the outstanding loan balance, including accrued interest, exceeds the policy’s cash value, the policy can lapse. A lapse terminates coverage, which has financial consequences. Policyholders must ensure sufficient cash value remains to support the loan and its interest.

Policy loans generally receive favorable tax treatment. They are not considered taxable income as long as the policy remains in force. The IRS views these loans as advances against the cash value. However, if a policy lapses or is surrendered with an outstanding loan, the loan amount may become taxable if it exceeds the premiums paid into the policy. This can result in a tax liability on the policy’s gain.

The portion of cash value used as collateral for a loan may not earn the same interest or dividends as the unencumbered cash value, or it may earn a different rate, depending on policy terms. Some policies allow the entire cash value to continue growing, while others adjust the crediting rate on the borrowed portion. Clarify this with the insurer to understand the impact on long-term accumulation.