When Can You Borrow From Life Insurance?

A life insurance policy loan offers a way to access funds accumulated within certain permanent life insurance policies. Policyholders borrow money from the insurer, using their policy’s accumulated cash value as collateral. This provides a means to obtain liquidity without fully withdrawing from the policy or immediately impacting its long-term benefits. The loan is not a direct withdrawal of the cash value itself, but rather a loan issued by the insurance company.

Types of Life Insurance Policies That Allow Borrowing

The ability to borrow from a life insurance policy is exclusively tied to policies that build cash value. These are generally categorized as permanent life insurance policies. Term life insurance, which provides coverage for a specific period and does not accumulate cash value, does not allow for policy loans.

Permanent life insurance options include Whole Life, Universal Life, Variable Universal Life, and Indexed Universal Life policies. Whole Life policies accumulate cash value at a guaranteed rate, ensuring predictable growth. Universal Life policies offer flexibility in premium payments and death benefits, with cash value growth tied to an interest rate set by the insurer. Variable Universal Life policies invest the cash value in sub-accounts similar to mutual funds, offering potential for higher returns but also carrying investment risk. Indexed Universal Life policies link cash value growth to a market index, providing potential for gains while offering some protection against market downturns.

Qualifying for a Policy Loan

Eligibility for a life insurance policy loan depends on the policy’s accumulated cash value. A certain amount of cash value must have built up before a loan can be taken. This typically requires the policy to have been in force for a minimum period, often two to five years, to allow sufficient cash value to accrue.

The amount a policyholder can borrow is limited by the available cash value, often up to a percentage of the policy’s cash surrender value. Many insurers allow policyholders to borrow up to 90% of the current cash value. There is no credit check or lengthy approval process required, as the loan is secured by the policy itself.

Understanding the Policy Loan Mechanism

When a policy loan is taken, the cash value of the policy acts as collateral. The insurer lends money to the policyholder, backed by the policy’s value. This allows the policy to remain in force and continue to earn interest or dividends on the full cash value, even while a loan is outstanding.

Interest accrues on the loan at a rate set by the insurer, which can be either fixed or variable. This interest is usually paid back to the insurance company. If the insured passes away with an outstanding loan balance, the death benefit paid to beneficiaries will be reduced by the amount of the outstanding loan plus any accrued interest.

Repaying a Policy Loan and Policy Impact

Policy loans offer flexibility regarding repayment, as there is no fixed repayment schedule. Policyholders can choose to repay the loan in a lump sum, make regular payments, or opt not to repay the loan at all. However, it is important to note that interest continues to accrue on the outstanding loan balance.

Failing to repay the loan, including the accumulating interest, can have several consequences for the policy. The outstanding loan balance and accrued interest will reduce the death benefit payable to beneficiaries. If the loan balance, combined with accrued interest, grows to exceed the policy’s cash value, the policy can lapse. A policy lapse due to an unpaid loan can lead to significant tax implications, as the outstanding loan amount may then be considered taxable income. Repaying the loan in full restores the policy’s full benefits and death benefit amount.

Tax Considerations for Policy Loans

Policy loans are generally considered debt, not income, and are typically tax-free when taken, provided the policy remains in force. This is because the policyholder is borrowing against their own asset rather than receiving a distribution of income. However, specific situations can trigger a taxable event.

A policy loan can become taxable if the policy lapses or is surrendered with an outstanding loan balance. In such cases, the outstanding loan amount, to the extent it exceeds the premiums paid, may be treated as taxable income.

Another scenario is if the policy is classified as a Modified Endowment Contract (MEC). A policy becomes an MEC if it receives premiums exceeding certain IRS limits within its first seven years, failing the “seven-pay test.” Loans from an MEC are taxed differently; they are treated on a “last-in, first-out” (LIFO) basis, meaning any gains are taxed first. Additionally, withdrawals or loans from an MEC taken before age 59½ may be subject to a 10% early withdrawal penalty. Interest paid on policy loans is generally not tax-deductible for the policyholder.