Borrowing Against Your Life Insurance Policy
Life insurance policies are designed to protect your loved ones — children, a spouse, your parents or even siblings — so that those who are dependent on you are financially covered if you die unexpectedly. But sometimes life events, from a global pandemic to layoffs, happen that require financial assistance in the here and now. Borrowing against your life insurance policy may be a fit for your needs.
If you’re considering whether or not to borrow against your life insurance policy, consider how it may impact your financial options in the future. If you’re in a financial bind, borrowing against your life insurance policy is a tempting way to quickly get money to help cover financial responsibilities for anything from rent and putting a down payment on a house to buying groceries and paying for medical expenses. But there are a few keys things to know about borrowing against your life insurance policy before making that decision.
What Are Policy Loans?
A policy loan, sometimes referred to as a life insurance loan, is the amount a policyholder can borrow at a specified rate of interest from an issuing life insurance company by using the insurance policy’s value as collateral.
While life insurance policy loans typically have lower interest rates than both credit cards and bank loans, you’re essentially taking from the cash value and borrowing against your death benefit when you take a policy loan. For that reason, it is important to note that if the policyholder dies before the loan is repaid, the insurance company will deduct the amount borrowed plus whatever interest has accumulated since the loan was awarded. Depending on the terms of the loan, interest may accrue regardless of whether monthly loan payments have been made.
Unlike other loans, however, there is flexibility in paying back a policy loan. But if you entirely stop making payments or don’t pay it back on time, you risk surrendering your life insurance policy and incurring tax penalties. And if you die before the loan is repaid, the money is deducted from your death benefit — meaning your beneficiary pays back the loan.
Which Life Insurance Policies Can You Borrow Against?
If you’re looking to borrow against your life insurance policy, it’s important to first know what type of policy you have. Policy loans are available, but only if you have what is known as a permanent life insurance policy.
- Whole life insurance, which is the most common
- Universal life insurance
- Variable life insurance
- Variable-universal life insurance
Each of these policies types provide death benefits and accrue cash value, which is what you’re able to draw from for a loan.
Term life insurance may be renewable, but ultimately only lasts for a specified number of years. Even though term life insurance policies are often a more affordable option, they are not eligible for loans. They can, however, be converted to whole life insurance policies.
How Do Policy Loans Work?
While you’re ultimately borrowing against your policy’s cash value, not your death benefit, it’s worth noting that the insurance company uses your policy as collateral for your loan. This basically means if the loan is not repaid, you’ll lose the cash value and reduce your overall death benefit — and potentially forfeit your coverage altogether.
Maximum Loan Amounts
The longer you’ve been paying toward your annual premium, the more money, or cash value, you have accumulated. Think of the cash value essentially like a savings account. It’s there until you remove it. You can withdraw funds from it, but it’s not going to repay itself and you’ll lose any money you would have earned in interest from the money sitting untouched in the account. The same is true when taking out a policy loan.
Most life insurance companies have guidelines regarding how much cash value needs to be accrued before you can borrow against it. They also define what percentage of cash value you can borrow. How much you can withdraw depends on how much you have available to you based on your specific insurance policy.
Taking Out Policy Loans
Unlike with a bank loan, there is no approval process. You will need to contact your life insurance company to initiate the loan.
Be sure to review the terms of the loan and request what is called an in-force illustration, which outlines the policy loan based on your plans and reflects how interest will be applied to your loan: in advance or in arrears. In the former, the insurance company will charge interest for the full year. In the latter, interest accrues daily and is charged at the end of the year.
Policy Loan Taxation
As long as you pay back your loan in timely fashion, you should not be taxed on it. The IRS does not consider the loan to be taxable income unless your policy lapses or is surrendered. Then you could be taxed on the amount of the cash value plus interest.
Paying Back Policy Loans
Taking a policy loan can be low stress. No one is going to knock on your door demanding you re-pay it. However, you’ll want to be sure you can pay it back in a timely manner to avoid unwanted taxes and forfeiting any death benefits. Always ensure that your life insurance policy is able to help your heirs as intended after you die.
What Are the Pros and Cons of Policy Loans?
As with most financial products on the market, there are pros and cons to taking out a policy loan. Consider each point carefully before making any decision.
- You can expect to receive money within five to 10 business days of request
- They typically offer lower interest rates than credit card or bank loans
- Policy loans do not affect credit rating
- There is no approval process or credit check
- You owe no explanation for requesting the loan
- There are no restrictions on how loan can be used
- The loan is tax-free loan — as long as the policy doesn’t lapse and the insurance company doesn’t surrender it
- There is no mandatory monthly payment
- You are technically not required to pay it back
- There are fewer assets to use or borrow against
- You’ll incur a reduction of total benefits to beneficiaries until the loan is fully repaid
- If you do not make payments, your debt could become equal to the policy’s cash value
- You risk losing your death benefit
- If your loan balance is more than the policy’s cash value, the insurance company will surrender your policy
- If your policy lapses or is surrendered, you are required to pay taxes on the loan balance plus interest since the IRS will count it as taxable income
Advice on Taking Out a Life Insurance Policy Loan
- Ask for an in-force illustration upon initiation and annually until the loan is fully repaid
- Carefully review the terms of the loan
- Be sure not to reduce your death benefit
- Don’t tamper with the guarantee
- Pay back the loan in a timely manner
3 Cited Research Articles
- FINRA.org. (2002, September 23). Should You Exchange Your Life Insurance Policy? Retrieved from |https://www.finra.org/investors/alerts/should-you-exchange-your-life-insurance-policy
- Insurance Information Institute. (2022). Life Insurance Basics. Retrieved from https://www.iii.org/article/life-insurance-basics
- American Council for Life Insurers. (n.d.) Glossary. Retrieved from https://www.acli.com/industry-facts/glossary