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 referred to as a “life insurance loan.” While they were traditionally known for their low-interest rates, that's not always the case anymore.
- While policy loans come with restrictions, they generally offer quick access to cash.
- Policy loans can be made when you have accumulated cash value in a universal or whole life insurance policy.
- Various options are available for paying back your loan, including paying only the annual interest or making periodic payments.
- If you don't pay back a policy loan, the interest and the loan amount may cut into the death benefit.
Understanding a Policy Loan
Need emergency access to cash? A policy loan, which accesses the cash value of a life insurance policy, may be an option. This only works when the policy is permanent life insurance, available as either whole life, or universal life.
Unlike term life insurance, which doesn't accumulate cash value, universal and whole life insurance policies have a cash component that grows over the policy's duration. 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, holders can borrow against the accumulated funds untaxed. Predicting when a whole life policy cash value will be available for a loan is difficult since insurers may not be able to estimate how the cash value will grow. One rule of thumb is that at least 10 years must pass before a policy loan is available.
Insurers have varying requirements on how much cash value must accumulate before a policy is eligible and what percentage 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.
A policy loan is one way of getting cash for an emergency, but it comes with the risk of reducing your death benefit.
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 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. Interest rates can be as high as 7% or 8%.
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. 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.
What's 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 any money to beneficiaries. Also,
interest rates have climbed in recent years and now stand around 7% or 8%.
What are a few benefits of a policy loan?
They 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. Indeed, you don’t have to pay it back at all.