Borrowing Against Your Life Insurance Policy

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.

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. This does not mean the beneficiary has to pay out of pocket, but the death benefit is reduced by the amount of the unpaid loan.

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.

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.

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.

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.

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.

As long as you pay back your loan in a 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, or the policy is considered a modified endowment contract. In these cases, you could be taxed on the amount of the cash value plus interest.

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.

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.