Which Life Insurance Can I Borrow From?

Life insurance offers financial protection to loved ones upon the insured’s passing. Some policies also accumulate cash value over time, which policyholders can access during their lifetime, often through a loan. Understanding which policies offer this feature and how these loans operate helps policyholders leverage their insurance.

Life Insurance Policies with Cash Value

Only life insurance policies that accumulate cash value allow for policy loans. This cash value represents a savings element within the policy that grows over time, separate from the death benefit. It takes several years for sufficient cash value to build before it can be accessed for loans.

Whole life insurance is a permanent policy with guaranteed cash value growth, fixed premiums, and lifelong coverage. Its cash value grows at a guaranteed interest rate, providing a predictable source for loans once sufficient value accrues. Policyholders can receive dividends with participating whole life policies, which can increase the cash value.

Universal life insurance also builds cash value, offering more flexibility in premium payments and death benefit adjustments. Its cash value grows based on an interest rate, which may have a guaranteed minimum, balancing growth potential and stability.

Variable universal life insurance ties its cash value growth to the performance of underlying investment sub-accounts, similar to mutual funds. This offers potential for higher growth but carries greater risk, as cash value can fluctuate with market performance. While it accumulates cash value, its volatile nature can influence the amount available for loans.

In contrast, term life insurance does not build cash value. It provides coverage for a specific period, such as 10, 20, or 30 years, and lacks a savings component. Therefore, term life insurance policies cannot be used to obtain policy loans.

How Policy Loans Work

A policy loan is a financial transaction where you borrow money from the insurance company, with your policy’s cash value serving as collateral. The cash value remains within the policy and continues to earn interest or investment gains, though the collateralized portion might earn a reduced rate. The insurer lends funds using the policy’s value as security.

The maximum loan amount is limited by the policy’s available cash surrender value, often up to 90% of this value, minus any existing loans or charges. It takes several years for a policy to accumulate sufficient cash value for a loan. The loan accrues interest, which is not tax-deductible for personal policies. Interest rates for policy loans range from 5% to 8%, and can be fixed or variable.

Policy loans are secured by your policy’s value. There is no fixed repayment schedule, offering policyholders flexibility in how and when they repay the loan.

Any outstanding loan balance, along with accrued interest, will reduce the death benefit paid to beneficiaries. For instance, if a policy has a $250,000 death benefit and a $50,000 outstanding loan, beneficiaries would receive $200,000. Policy loans are not considered taxable income. However, if the policy lapses or is surrendered with an outstanding loan exceeding the policy’s cost basis, the loan amount can become taxable income. To initiate a loan, policyholders contact their insurer.

Managing Your Policy Loan

The flexible repayment structure means there is no strict requirement to repay the loan during the insured’s lifetime. Policyholders can make partial payments, repay the loan in a lump sum, or choose not to repay it. However, interest continues to compound on any outstanding loan balance, which can increase the total amount owed over time.

If the loan is not repaid, accruing interest can reduce the policy’s cash value. A risk arises if the outstanding loan balance, combined with accrued interest, exceeds the policy’s cash value. The policy could lapse. When a policy lapses with an outstanding loan, the loan amount, to the extent it exceeds the policy’s cost basis, becomes taxable income. This can create an unexpected tax liability, even if no cash was directly received.

An outstanding loan can also affect the amount of dividends a participating whole life policy earns. Some insurers use a “direct recognition” approach, where the portion of cash value securing the loan may earn a different dividend rate. Other insurers use “non-direct recognition,” where loan activity affects all policy values uniformly. This can impact the growth of the policy’s cash value and future dividend payouts.

Regularly reviewing policy statements helps monitor the loan balance and remaining cash value. This prevents the loan from growing to a point where it risks lapsing the policy. If a loan becomes too large, policyholders might consider making partial repayments or exploring policy adjustments with their insurer to avoid potential lapse and adverse tax consequences.