What is Policy Loan
A policy loan is issued by an insurance company that uses the cash value of a person's life insurance policy as collateral. Sometimes these loans 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 If a borrower fails to repay a policy loan, the money is withdrawn from the insurance death benefit.
BREAKING DOWN Policy Loan
If someone needs access to emergency cash, getting a policy loan, which accesses the cash value of a life insurance policy, is one option – 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 or whole life insurance has 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, policyholders can borrow against the accumulated funds and receive the funds tax-free. However, since 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.
Policy Loans Don't Require Repayment
One beneficial aspect of loans against cash value is you don't have to repay them. However, if possible, if the loan is not paid back before death, the insurance company will reduce the face amount of the insurance policy when the death benefit is paid.
If you do pay back all or a portion of the loan, 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 percent.
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.