Which Insurance Policies Can You Borrow From?

Life insurance policies provide financial protection for beneficiaries and allow policyholders to access funds during their lifetime through policy loans. These loans allow individuals to borrow against the accumulated cash value within certain types of insurance products. Understanding how these loans function and which policies support them is important for leveraging insurance coverage beyond its death benefit.

Policies That Allow Borrowing

Only permanent life insurance policies accumulate cash value, which serves as the basis for policy loans. Term life insurance, designed solely for a specific period of coverage, does not build cash value and therefore does not allow borrowing. The primary types of permanent policies that offer this feature are Whole Life and Universal Life insurance.

Whole Life insurance policies provide lifelong coverage with a guaranteed cash value component. A portion of each premium payment is allocated to this cash value, which grows over time at a guaranteed interest rate. This consistent growth makes the cash value a reliable source for borrowing.

Universal Life (UL) insurance policies offer more flexibility than Whole Life, allowing policyholders to adjust premiums and death benefits within certain limits. A segment of the premiums paid into a Universal Life policy contributes to a cash value account. This cash value grows based on interest rates set by the insurer, which can be fixed or linked to market performance, typically with a guaranteed minimum rate. Indexed Universal Life (IUL) policies tie cash value growth to a stock market index, offering potential for higher returns with a floor and cap on gains.

How Policy Loans Work

A policy loan is not a withdrawal of funds from the cash value; instead, it is a loan provided by the insurance company, with the policy’s cash value serving as collateral. The cash value remains intact and continues to grow, earning interest or dividends, even while a loan is outstanding.

Interest accrues on the outstanding loan balance, similar to other types of loans. Interest rates for policy loans can be fixed or variable, typically ranging from 5% to 8%, which can be lower than rates for personal loans or credit cards. The interest charged on the loan is paid to the insurance company.

If a policyholder dies with an outstanding loan balance, the unpaid loan amount, including any accrued interest, is deducted from the death benefit paid to beneficiaries. For instance, a $250,000 death benefit with a $50,000 outstanding loan would result in a $200,000 payout.

Policy loans are generally not considered taxable income as long as the policy remains in force and the loan amount does not exceed the premiums paid. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount exceeding the premiums paid (cost basis) may become taxable as ordinary income.

Accessing and Managing Your Policy Loan

Once a permanent life insurance policy has accumulated sufficient cash value, the policyholder can request a loan from the insurer. The amount available to borrow is usually a percentage of the cash value, commonly up to 90%. There is generally no credit check or lengthy approval process required because the policy’s cash value serves as collateral. Funds can often be received within a few days.

Managing a policy loan offers considerable flexibility in repayment. Unlike traditional loans, there is usually no strict repayment schedule, allowing policyholders to make payments at their discretion. Options include making periodic payments of principal and interest, paying only the annual interest, or even choosing not to repay the loan at all. If only interest is paid, the principal loan balance remains unchanged.

If the loan principal and interest are not repaid, the outstanding balance continues to grow. This growing loan balance reduces the policy’s cash value and, consequently, the death benefit. If the outstanding loan balance, plus accrued interest, eventually exceeds the policy’s cash value, the policy can lapse, leading to termination of coverage. The policyholder then loses insurance coverage, and the unpaid loan may trigger a taxable event if the loan amount exceeds the premiums paid into the policy.