What Is a Policy Loan?
A policy loan is issued by an insurance company and uses the cash value of a person’s life insurance policy as collateral. Sometimes it is are referred to as a “life insurance loan.” Traditionally, policy loans were issued at a very low interest rate, but that is no longer universally true. If a borrower fails to repay a policy loan, the money is withdrawn from the insurance death benefit.
How a Policy Loan Works
If someone needs access to emergency cash, getting a policy loan, which accesses the cash value of a life insurance policy, is one option, but only if the policy is permanent life insurance, available as either whole life or universal life. Unlike term life insurance, which does not accumulate cash value, universal and whole life insurance have a cash component, especially later on. During the early years of the policy the premium mostly goes to funding the indemnity benefit, but the cash value continues to increase as the policy matures.
As cash value builds in a whole life policy, policy holders can borrow against the accumulated funds and receive their money tax free. However, as insurers usually can’t say how fast or how much cash value will increase, it’s hard to say when a whole life policy cash value would be available for a loan, although it is generally accepted that at least 10 years must pass before a policy loan is an option. Insurers also have varying requirements on how much cash value must accumulate before a policy is eligible and what percentage of the cash value can be loaned. In a policy loan, you’re not actually withdrawing the cash value. It’s simply being used as collateral on the loan.
[Important: A policy loan is a good way of getting cash for an emergency.]
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. Also, the money you receive is not taxable as long as it is equal to or less than the life insurance premiums you have paid. Finally, you don’t have a repayment schedule or repayment date. Indeed, you don’t have to pay it back at all.
However, if the loan is not paid back 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. If you do pay back all or a portion of the loan, your options include periodic payments of principal with annual payments of interest, paying annual interest only or deducting interest from the cash value. Interest rates can be as high as 7% or 8%.
If a policy loan isn’t repaid, interest can significantly cut into the death benefit, which can put the policy at risk of not providing any money to beneficiaries. As such, it is smart to at least make interest payments, so the policy loan doesn’t grow.
In a worst-case scenario, 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 is considered taxable income by the IRS, and the bill could be a hefty one.