Which Life Insurance Policy Can You Borrow From?
Learn which life insurance policies allow you to borrow from their cash value. Understand how these policy loans work and what to consider.
Life insurance serves as a financial safeguard, providing a death benefit upon the insured’s passing. Beyond this, certain policies offer the ability to borrow money against their accumulated value. This option allows policyholders to access funds during their lifetime. This article explores the types of policies that permit borrowing, their mechanics, and important considerations.
Policies That Allow Borrowing
The ability to borrow from a life insurance policy is linked to its cash value component. Cash value is a portion of premiums paid into permanent life insurance policies that grows tax-deferred. This accumulated value can be accessed by the policyholder.
Whole life insurance is a permanent policy where cash value grows predictably and is guaranteed. A portion of each premium contributes to this cash value, which steadily increases over the policy’s life. This guaranteed growth provides a reliable source for policy loans.
Universal life insurance offers more flexibility than whole life, allowing policyholders to adjust premium payments and death benefits. Cash value accumulation can vary depending on the interest crediting rate, which may be fixed or adjustable. While cash value grows, its rate might fluctuate.
Variable universal life insurance allows policyholders to direct cash value into various investment sub-accounts. The cash value is not guaranteed and can fluctuate significantly based on investment performance. This introduces higher risk and potential for greater growth or loss.
In contrast, term life insurance does not build cash value. Term policies are designed purely for protection, providing a death benefit only if the insured passes away within a specific period. Without a cash accumulation component, term policies do not offer borrowing options.
How Policy Loans Work
A policy loan is a loan from the insurance company that uses your policy’s cash value as collateral. The policy remains in force, and the cash value continues to exist with a lien against it. The loan amount is typically limited to a percentage of the cash value, often up to 90%.
Policy loans accrue interest, set by the insurer at a fixed or variable rate. Interest begins to accumulate immediately and is generally paid back to the insurance company. While interest is paid on the loan, the collateralized cash value may continue to earn interest or dividends, potentially offsetting the loan interest.
Repayment of a policy loan is flexible, lacking a strict schedule like traditional bank loans. Policyholders can choose to repay partially or in full, or not at all, as long as the policy has sufficient cash value to cover the outstanding loan and interest. This flexibility requires careful management.
An outstanding policy loan impacts the death benefit. Any unpaid loan balance, plus accrued interest, reduces the death benefit paid to beneficiaries. While the policy provides access to funds during life, it may diminish the financial legacy if the loan is not repaid.
The portion of the cash value that secures the loan may be subject to different growth terms. Some policies might reduce the interest or dividend crediting rate on the borrowed portion, potentially slowing its overall growth. This can affect the long-term compounding potential of the policy’s cash value.
It is important to distinguish a policy loan from a cash value withdrawal. A withdrawal directly removes funds from the cash value, permanently reducing both the cash value and the death benefit. Withdrawals are generally tax-free up to the amount of premiums paid, but any gains withdrawn above this may be taxable. In contrast, a policy loan is generally not considered taxable income as long as the policy remains in force, as it is a debt, not a distribution of gains.
Important Considerations for Borrowing
Utilizing a policy loan requires careful evaluation of its long-term implications. A significant risk is policy lapse if the loan and accrued interest grow too large. If the outstanding loan balance, including interest, surpasses the policy’s cash value, the policy can terminate. This often occurs if premium payments cease or loan interest is not paid, eroding the cash value over time.
If a policy lapses with an outstanding loan, there can be significant tax implications. The loan amount, particularly if it exceeds the premiums paid, may become taxable income to the policyholder. This creates an unexpected tax liability, as the previously non-taxable loan is reclassified as a distribution of policy gains upon lapse.
Another consideration is the opportunity cost of borrowing from the cash value. The portion of cash value used as collateral no longer fully contributes to the policy’s tax-deferred growth or earns dividends at its prior rate. This can slow overall cash value accumulation, potentially affecting the policy’s long-term financial performance and reducing future access to funds.
Policyholders should compare a life insurance policy loan to alternative financial options. While policy loans offer advantages like no credit checks and flexible repayment, other options such as personal loans or home equity lines of credit may have different interest rates, repayment terms, and tax implications. Evaluating these alternatives based on individual financial needs is prudent.
Understanding the specific terms and conditions of an individual life insurance policy regarding loans is important. Each policy may have unique rules concerning loan limits, interest rates, and the impact on cash value growth and death benefits. Reviewing the policy document or consulting an insurance advisor ensures a clear understanding before taking out a loan.