What Types of Insurance Can You Borrow From?

Certain types of insurance policies offer a financial feature, allowing policyholders to access accumulated value through loans. Unlike traditional borrowing methods, these loans are facilitated directly through the insurance policy itself. This enables individuals to leverage their insurance coverage as a resource for various financial needs. The availability of this option depends on the specific structure and design of the insurance product.

Types of Insurance Policies You Can Borrow From

Only insurance policies that accumulate cash value allow borrowing. Whole life insurance is a prime example, known for its guaranteed cash value growth. This cash value builds a reserve that policyholders can access. The guaranteed nature of its growth makes it a stable asset for policy loans.

Universal life insurance policies also accumulate cash value, offering more flexibility in premium payments and death benefits compared to whole life. The cash value in a universal life policy grows based on an interest rate, which can be fixed or variable. This accumulated value also serves as a source for policy loans. Variable universal life insurance is another type that allows borrowing, though its cash value is tied to investment performance, introducing more risk and potential for fluctuation.

Many common types of insurance policies do not offer a borrowing feature because they lack a cash value component. Term life insurance, for instance, provides coverage for a specific period and does not build cash value. Therefore, it cannot be used as collateral for a loan. Health, auto, and homeowners insurance are designed purely for protection against specific risks and do not accumulate financial value.

Understanding How Policy Loans Work

A policy loan is not a conventional loan from a bank or a third-party lender; instead, it is an advance provided by the insurance company itself, using the policy’s cash value as collateral. The money borrowed is not directly withdrawn from the cash value but is a loan from the insurer, with the policy’s accumulated value serving as security for the amount advanced. The cash value typically continues to earn interest or dividends, although at a potentially reduced rate for the portion securing the loan.

The amount available for a policy loan is limited to a percentage of the policy’s cash surrender value, which is the cash value minus any surrender charges or outstanding loans and interest. For example, a policy might allow borrowing up to 90% of its cash value. Interest accrues on the loan, and the policyholder is provided with flexible repayment terms. Repayment of the principal and interest is not mandatory on a strict schedule, but allowing interest to accumulate can have consequences.

The policyholder can choose to repay the loan at their convenience, make regular payments, or not repay it at all during their lifetime. Any outstanding loan balance, along with accrued interest, will reduce the death benefit paid to beneficiaries. It is important to distinguish a policy loan from a cash value withdrawal. A withdrawal permanently reduces the policy’s cash value and death benefit, and if the amount withdrawn exceeds the premiums paid, the excess could be taxable income.

Key Considerations for Policy Loans

Taking a loan against an insurance policy has several implications. One significant factor is the impact on the policy’s death benefit. Any unpaid loan balance and accumulated interest will directly reduce the death benefit paid to the beneficiaries upon the policyholder’s passing. This means beneficiaries will receive a smaller payout than the policy’s face amount.

Policy loans are tax-free as long as the policy remains in force. If the policy lapses or is surrendered with an outstanding loan, the loan amount can become taxable income to the extent it exceeds the premiums paid into the policy. This could create an unexpected tax liability for the policyholder. Such an event would require reporting the income on federal income tax returns.

The portion of the cash value used to secure the loan may not continue to earn dividends or interest at the same rate as the unborrowed portion. While the unborrowed cash value may continue to grow, the segment linked to the loan might experience reduced growth or even no growth, depending on the policy’s terms and the insurer’s crediting methods. This could slow down the overall cash value accumulation within the policy.