Policy Loan: Definition, How They Work, Benefits, and Downsides

A policy loan, issued by an insurance company, uses the cash value of a life insurance policy as collateral. Also called a "life insurance loan," it often has lower interest rates than a personal loan and you can use the money for any purpose. You don't need to repay this loan before you die. But there are also downsides to consider.

Key Takeaways

  • Policy loans provide a source of funds that uses your policy's cash value as collateral.
  • You must have accumulated cash value in a permanent life insurance policy to get a policy loan.
  • Options for repaying your loan include paying only the annual interest or making periodic payments.
  • You don't need to pay back a policy loan before you die, but a balance will reduce the death benefit.

How a Policy Loan Works

A policy loan allows you to access the cash value of a life insurance policy using the cash value as collateral. You can usually borrow a certain percentage of the cash value and use the money as you'd like. You won't need to repay this loan before you die. If you don't repay the loan with interest, the death benefit will be reduced.

You can accumulate a cash value with permanent life insurance that is invested and can be used for loans and withdrawals. A cash value component is not available with term life insurance, which is only for a specific time period.

As cash value builds in a whole life policy, holders can borrow more against the accumulated funds untaxed. Funds for a loan from a permanent life insurance policy are available according to the insurer's terms, such as after 10 years. Insurers have varying requirements on how much cash value must accumulate before a policy is eligible and what percentage can be loaned.

With a policy loan, you’re not withdrawing the cash value. You are using it as collateral on a loan that can accumulate interest.

Pros and Cons of a Policy Loan

Getting a policy loan is usually quick and easy. You don’t have to go through an approval process, because you are borrowing against your own assets. You can use the funds in any way you wish.

Another advantage of a policy loan is that the funds are not taxable as long as they are equal to or less than the amount of life insurance premiums you have paid.

Also, policy loans don’t have a repayment schedule or repayment date. Infact, you don’t have to pay it back at all. However, if the loan isn't paid before death, the insurance company will reduce the face amount of the insurance policy by what is still owed when the death benefit is paid.

Payback options include periodic payments of principal with annual payments of interest, paying annual interest only, or deducting interest from the cash value.

If a policy loan isn’t repaid, interest can cut into the death benefit, which can put the policy at risk of not providing any money to beneficiaries. Consider making at least the interest payments so the policy loan doesn’t grow beyond your cash value.

If added interest increases the loan value beyond the cash value of your insurance, your life insurance policy could lapse and be terminated by the insurance company. In such a case, the policy loan balance plus interest can be considered taxable income by the IRS, and the bill could be significant.

How Much Can You Borrow From an Insurance Policy?

The amount you can borrow from your insurance policy is set by your insurer. Generally it's no more than a certain percentage of your policy's cash value, such as up to 90%.

What Are the Downsides of a Policy Loan?

If a policy loan isn’t repaid, interest can cut into the death benefit, which can put the policy at risk of not providing sufficient money or any money at all to beneficiaries.

What Are a Few Benefits of a Policy Loan?

Policy loans offer easy access to cash for those with permanent life insurance policies. Borrowers don’t have to go through the usual approval process, since they are borrowing against their own assets. The funds can be used for any purpose, and they aren't taxable as long as the amount is equal to or less than the life insurance premiums paid. Borrowers don't have a repayment schedule or repayment date.

The Bottom Line

A policy loan can be a useful tool to provide financing for major expenses. but there are downsides to consider as well. If you are considering a policy loan, you might want to consult with a financial advisor who can explain how it would fit into your overall long-term financial plan.

Article Sources
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  2. Progressive. "Pros and Cons of Life Insurance Loans."

  3. Experian. "Can I Withdraw Money From My Life Insurance?"

  4. Johnhancockinsurance.com. "Income Taxation of Life Insurance." p. 7.