What Types of Life Insurance Can You Borrow Against?

Certain life insurance policies accumulate a cash value that policyholders can access during their lifetime. This feature distinguishes them from policies that solely provide coverage for a specific period, offering a financial resource beyond providing protection to beneficiaries.

Policies with Cash Value

Only permanent life insurance policies build cash value, unlike term life insurance. A portion of premiums is allocated to this cash value, which grows tax-deferred. Taxes on accumulated earnings are typically not due until funds are accessed.

Whole life insurance is a traditional permanent coverage where cash value grows at a guaranteed fixed interest rate. Premiums remain level, offering predictability. Some policies may receive dividends, which, if reinvested, can enhance the policy’s cash value and death benefit.

Universal life (UL) insurance provides flexibility in premium payments and death benefit amounts. The cash value typically grows based on current interest rates, often with a guaranteed minimum rate. This allows policyholders to adjust payments based on financial circumstances.

Variations of universal life insurance exist, offering different approaches to cash value growth. Variable universal life (VUL) insurance ties cash value growth to investment sub-accounts, such as stocks or bonds, offering potential for higher returns but also increased risk. Indexed universal life (IUL) insurance links cash value growth to a market index, like the S&P 500. These policies often include a floor against market downturns and a cap limiting maximum gains.

Understanding Policy Loans

A policy loan allows access to the accumulated cash value within a permanent life insurance policy. Policyholders borrow funds from the insurance company, using their policy’s cash value as collateral. This is distinct from a withdrawal, as the cash value remains intact and continues to earn interest or dividends.

Policy loans do not require a traditional credit check or formal application. Since the policy’s cash value secures the loan, approval is generally guaranteed once sufficient cash value has accumulated.

Interest accrues on the outstanding loan balance, and rates are often more competitive than those found with personal loans or credit cards. If the policyholder dies with an outstanding loan, the death benefit paid to beneficiaries will be reduced by the loan amount plus any accrued interest. The policy generally remains in force as long as the loan balance does not exceed the cash value.

Accessing and Managing Policy Loans

Accessing a policy loan typically requires a request to the insurance company. The amount that can be borrowed is usually limited to a percentage of the policy’s accumulated cash value, often up to 90%. While funds can be received quickly, it can take several years for a policy to build sufficient cash value to support a loan.

Policy loans offer a flexible repayment structure. There is typically no fixed repayment schedule, allowing policyholders to choose how and when they repay the loan. Options include making regular principal and interest payments, paying only the interest, or making no payments, allowing the loan balance to grow.

Not repaying a policy loan carries consequences. Interest continues to accrue on the outstanding balance, increasing the total amount owed. If the loan, including accrued interest, is not repaid before the policyholder’s death, the outstanding balance will be deducted directly from the death benefit.

If the outstanding loan balance, with accumulated interest, grows to exceed the policy’s cash value, the insurance company may terminate the policy, causing it to lapse. This termination results in the loss of all insurance coverage, and it can also trigger a taxable event.

Tax Considerations and Policy Impact

Policy loans are generally considered debt, not income, and are typically not subject to income tax as long as the life insurance policy remains in force. The interest charged on the loan is also typically not tax-deductible.

An exception to the tax-free nature of policy loans arises if the policy lapses or is surrendered while an outstanding loan exists. The amount of the loan that exceeds the premiums paid into the policy can become taxable income. The IRS may treat the unpaid loan as a distribution, making any gain within the policy subject to ordinary income tax.

An outstanding policy loan directly impacts the death benefit. If the policyholder passes away before repaying the loan, the outstanding loan balance, including any accrued interest, is deducted from the death benefit amount paid to beneficiaries.

Taking a loan can affect the policy’s cash value growth. While cash value typically continues to earn interest or dividends even with a loan, some insurers may apply a different crediting rate to the portion securing the loan. This practice, known as direct recognition, can slow cash value growth and impact long-term projections. Consulting a qualified tax professional is advisable for personalized guidance.