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 life insurance policy, meaning either a whole life insurance or universal life insurance policy.
Term life insurance, a cheaper and more suitable option for many people, does not have a cash value. It is designed to last for a limited period of time, which is generally anywhere from one to 30 years. However, in some instances, a term life policy can be converted to a permanent policy in which cash value can build.
- Borrowing from your life insurance policy can be an easy way to get cash in hand when you need it.
- You can only borrow against a whole life insurance policy or a universal life insurance policy.
- Policy loans reduce the death benefit if not paid off.
- Life insurance companies add interest to the loan balance, which if unpaid can cause the policy to lapse.
- Only permanent life insurance builds cash value. Term policies do not.
Policies You Can Borrow From
Both whole life and universal life insurance policies are more expensive than term, but have no pre-determined expiration date. If sufficient premiums are paid, the policy is in force for the lifetime of the insured. While the monthly premiums are higher than term, money paid into the policy that exceeds the cost of insurance builds in a cash value account that's part of the policy. The purpose of the cash value is to offset the rising cost of insurance as you age. This is so premiums can remain level throughout life and not rise to unaffordable amounts in your later years.
Permanent life insurance has a few important values: the face value, the death benefit (often the same as the face value), and the cash value. One common misconception is that the cash value increases the death benefit. This is only true on certain types of permanent policies; on most policies it does not increase the death benefit.
Money in the cash value grows at a rate that depends on the type of policy. For example, in a regular universal life policy, it grows based on current interest rates, while in a variable universal life policy, the cash value is invested by the owner in the stock market (and grows accordingly). It usually takes at least a few years for the cash value to build to sufficient levels to take out a 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 as long as the policy stays active (provided it's not a modified endowment contract).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.
A policy loan reduces your available cash value and death benefit. If you pass while owing money on a life insurance loan, it will reduce the amount your beneficiaries receive.
Paying Back the Loan
Even with low interest rates and a flexible payback schedule, it's important that you pay the loan back in a timely manner—on top of your regular premium payments. If unpaid, interest is added to the balance and accrues, putting your loan at risk of exceeding the policy's cash value and causing your policy to lapse. If that happens, it's likely you'll owe taxes on the amount you borrowed.
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.
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 potential pitfalls:
- You reduce the death benefit: Taking money out of the life insurance policy while you are alive could reduce the survivor benefit.
- You 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.
- You 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 accumulates a 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 and to make cash value withdrawals. When you take a loan against your policy, your insurer lends 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 can continue to accumulate—but it's important to check with your insurance company how interest and any dividends will be determined and paid when you have an active loan.
Policy loans can be useful financial tools, but they can also create financial turmoil. If you don't make interest payments, your policy could lapse and the entire loan amount could become taxable. And if you pass away, the loan amount and any interest owed will be taken out of the death benefit, which could significantly impact your beneficiaries. Be sure to thoroughly consider the pros and cons of life insurance policy loans in the context of your situation before taking one out.