While borrowing from your life insurance policy can be a quick and easy way to get cash in hand when you need it, there are a few specifics to know before borrowing. Most importantly, you can only borrow against a permanent or whole life insurance policy.
Term life insurance, a cheaper and suitable option for many people, does not have a cash value and expires at the end of the term, which is generally anywhere from one to 30 years. However, in some instances, term life policies can be converted to a whole life policy that may make it eligible for a life settlement payment.
- Borrowing from your life insurance policy can be a quick and easy way to get cash in hand when you need it.
- You can only borrow against a permanent or whole life insurance policy.
- Policy loans are borrowed against the death benefit, and the insurance company uses the policy as collateral for the loan.
- Life insurance companies add interest to the balance, which accrues whether the loan is paid monthly or not.
- Only permanent life insurance builds cash value. Term policies do not.
Policies You Can Borrow From
A whole life policy is a more expensive type of life insurance, but it has no expiration date. The term lasts the lifetime of the insured. While the monthly premiums may be higher, money paid into the policy that exceeds what is needed for the death benefit is invested by the life insurance company, creating a cash value after a few years.
A whole life policy essentially has two values: the face value or death benefit, and the cash value that acts as a savings account. Once the money invested increases the amount of the death benefit, the tax-free cash value can then be borrowed against. It is also important to understand that the policy loan is not taken out of your death benefit but borrowed against it, and the insurance company uses your policy as collateral for the loan.
How a Life Insurance Loan Works
Unlike a bank loan or credit card, policy loans do not affect your credit, and there is no approval process or credit check since you are essentially borrowing from yourself. When borrowing on your policy, no explanation is required about how you plan to use the money, so it can be used for anything from bills to vacation expenses to a financial emergency.
The loan is also not recognized by the IRS as income, therefore it remains free from tax (provided it's not a modified endowment contract). However, it's still expected that a policy loan will be paid back with interest, though the interest rates are typically much lower than on a bank loan or credit card, and there is no mandatory monthly payment.
Because no cash is removed from your policy when you borrow against it, the cash value keeps growing as dividends are credited. In some cases, the dividends may be able to cover the interest on the loan.
Paying Back the Loan
Even with low interest rates and a flexible payback schedule, it's important for the loan to be paid back in a timely manner. Unless it is paid out-of-pocket, interest is added to the balance and accrues whether the bill is being paid monthly or not, putting your loan at risk of exceeding the policy's cash value and causing your policy to lapse.
Insurance companies generally provide many opportunities to keep the loan current and prevent lapsing. If the loan is not paid back before the insured person's death, the loan amount plus any interest owed is subtracted from the amount the beneficiaries are set to receive from the death benefit.
In the event of a policy lapse, taxes must be paid on the cash value.
Steve Kobrin, LUTCF
The firm of Steven H. Kobrin, LUTCF, Fair Lawn, NJ
You can borrow money from life insurance that has a cash account for use while the insured is alive. But here are three pitfalls to avoid:
- Don't reduce the death benefit: Taking money out of the life insurance policy while you are alive could reduce the survivor benefit.
- Don't tamper with the guarantee: Permanent insurance guarantees are based on certain assumptions. Chief among these is that you will stick to your premium payments and accumulate cash at a certain level. If you take cash out, you may deplete the amount required to ensure the guarantee.
- Don't end up paying more money: Some permanent policies will even ensure the guarantee when you take out cash, but at a cost that could force you to pay more premium to cover the difference.
How Much Can You Borrow Against Your Life Insurance Policy?
Each insurance company will have different rules in place, but in general, the most you can borrow against your life insurance is up to 90% of its cash value.
How Soon Can You Borrow Against a Life Insurance Policy?
You can borrow from a life insurance policy as soon as there is enough cash value built up to take a loan in the amount you need. Depending on how your policy is structured, this can take several years to accrue.
Which Types of Life Insurance Policies Can You Borrow Against?
You can borrow from permanent life insurance policies that build cash value. These would typically include whole life and universal life (UL) policies. You cannot borrow against a term policy since there is no cash value associated with it.
Can I Borrow Against a Term Life Policy?
No. Because term insurance does not have a cash value component, there is nothing to borrow.
The Bottom Line
Permanent life insurance that accrues cash value can provide certain living benefits, in addition to its death benefit. Among these include the ability to borrow against the cash value of the policy. Unlike other types of borrowing, when you take a loan against your policy, your insurer loans you the money and uses the cash in your policy as collateral—you do not actually withdraw any money from the policy itself. This means that the policy's cash value keeps growing with dividends.
In some cases, the dividends may even be sufficient to cover the interest on the loan, making the borrowed money "free" in that respect. Of course, the loan will have to be paid back eventually. If you pass away, the loan amount and any interest owed will be taken out of the death benefit.