When Can You Borrow From Your Life Insurance?

Life insurance policies can serve as a source of funds through policy loans. This involves borrowing against the accumulated value within the policy, rather than directly from the insurance company’s general assets.

Eligibility for Policy Loans

Accessing a life insurance policy loan depends on the type of policy held and the amount of cash value accumulated. Only permanent life insurance policies, which build cash value over time, are eligible for these loans.

Whole life insurance and universal life insurance are the primary types of policies that build cash value and permit policy loans. In whole life policies, cash value grows at a guaranteed fixed rate, offering predictability in its accumulation. Universal life policies offer more flexibility, with cash value growth often linked to current interest rates or market performance, though many include a guaranteed minimum interest rate.

Conversely, term life insurance policies do not accumulate cash value and therefore do not allow for policy loans. For eligible permanent policies, the cash value must have grown sufficiently to serve as collateral for the loan. It typically takes several years, often between two to ten years, for a policy to build enough cash value to be a meaningful source for borrowing. The amount that can be borrowed is usually limited to a percentage of the accumulated cash surrender value, commonly around 90%.

Understanding Policy Loan Mechanics

A life insurance policy loan functions as an advance against the policy’s own cash value, with that cash value serving as collateral. The funds for the loan do not originate from the insurer’s general assets; rather, the insurance company lends money to the policyholder, using the policy’s cash value as security. An advantage of this structure is that the policy’s cash value can continue to grow, potentially earning interest or dividends, even while a loan is outstanding.

Interest accrues on the outstanding loan balance, similar to other types of loans. These interest rates are typically set by the insurer and can be either fixed or variable, commonly ranging between 5% and 8%.

There is typically a maximum amount that can be borrowed, which is often up to 90% of the policy’s cash surrender value. If the policyholder dies with an outstanding loan balance, including any accrued interest, that amount is deducted from the death benefit paid to the beneficiaries.

A significant risk associated with policy loans is the potential for policy lapse. If the outstanding loan balance, along with accrued interest, grows to exceed the policy’s cash value, the policy can terminate.

Accessing and Managing Your Policy Loan

The process for obtaining a life insurance policy loan is generally straightforward. Policyholders typically initiate the process by contacting their insurance company. There is no credit check or lengthy approval process involved, as the loan is secured by the policy’s own cash value. Once approved, funds are typically disbursed via direct deposit or check.

Policy loans offer considerable flexibility regarding repayment. Unlike conventional loans, there is usually no fixed repayment schedule or mandatory monthly payments. Policyholders have the option to repay the loan in a lump sum, make periodic payments, or even choose not to repay the principal at all. Many policyholders opt to at least pay the interest annually to prevent the loan balance from increasing.

Choosing not to repay the loan carries significant consequences. Any outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries upon the policyholder’s death. If the loan balance plus accumulated interest grows to exceed the policy’s cash value, the policy can lapse, leading to a loss of coverage. Should a policy lapse with an outstanding loan, the unpaid loan amount may become subject to taxation.

Tax Implications of Life Insurance Loans

Policy loans are generally not considered taxable income when they are taken out, provided the policy remains in force. This is because the loan is viewed as borrowing against one’s own property, the policy’s cash value, rather than a withdrawal of earnings or a distribution of income. The loan is essentially a debt owed to the insurer, with the policy’s cash value serving as collateral.

However, certain circumstances can trigger a taxable event. The primary scenario where a policy loan becomes taxable is if the policy lapses or is surrendered with an outstanding loan balance. In such cases, the unpaid loan amount, up to the extent that it exceeds the policy’s cost basis (the total premiums paid into the policy), can be treated as taxable income.

A distinct consideration arises with policies classified as Modified Endowment Contracts (MECs). A life insurance policy becomes a MEC if it is overfunded, meaning premiums paid exceed specific IRS limits within the first seven years. For MECs, loans are treated differently for tax purposes; they are subject to “last-in, first-out” (LIFO) rules, meaning any earnings are considered to be distributed first and are immediately taxable. Additionally, if the policyholder is under age 59½, a 10% penalty may apply to the taxable portion of the loan. Once a policy is designated as a MEC, this classification is irreversible. It is also important to note that interest paid on policy loans is typically not tax-deductible for individuals.