How Can I Borrow Money From My Life Insurance Policy?

While borrowing from your life insurance policy can be a quick and easy way to get cash when you need it, there are a few details to be aware of before you borrow. Most importantly, you can only borrow against a permanent life insurance policy, which can be either whole life or universal life.

Term life insurance, which is a less expensive and more appropriate option for many people, does not have a cash value. It is intended to last for a specific amount of time, which can range from one to thirty years. In some cases, however, a term life policy can be converted to a permanent policy with cash value.

Policies You Can Borrow From

Whole life and universal life insurance policies are more expensive than term life insurance policies, but they have no set expiration date. If sufficient premiums are paid, the policy is valid for the insured's entire life. While the monthly premiums are higher than those of term insurance, money paid into the policy that exceeds the cost of insurance accumulates in a cash value account that is part of the policy. The cash value is intended to offset the rising cost of insurance as you age. This is done so that your premiums remain consistent throughout your life and do not rise to unaffordable levels in your later years.

The face value, death benefit (often the same as the face value), and cash value are the three most important values in permanent life insurance. One common misunderstanding is that the cash value boosts the death benefit. This is only true for certain types of permanent policies; it does not increase the death benefit on most policies.

The rate at which money in the cash value grows depends on the type of policy. In a regular universal life policy, for example, it grows based on current interest rates, whereas in a variable universal life policy, the cash value is invested in the stock market by the owner (and grows accordingly). It usually takes at least a few years for the cash value to accumulate to the point where a loan can be obtained.

How a Life Insurance Loan Works

Policy loans, unlike bank loans or credit cards, have no effect on your credit, and there is no approval process or credit check because you are essentially borrowing from yourself. Borrowing on your policy requires no explanation of how you intend to use the funds, so it can be used for anything from bills to vacation expenses to a financial emergency.

The loan is also not considered income by the IRS, so it is tax-free as long as the policy remains active (provided it is not a modified endowment contract). A policy loan is still expected to be repaid with interest (though the interest rates are typically much lower than on a bank loan or credit card), and there is no required monthly payment.

Paying Back the Loan

Even with low interest rates and a flexible repayment schedule, it's critical that you repay the loan on time—on top of your regular premium payments. If the loan is not paid, interest is added to the balance and accrues, putting your loan at risk of exceeding the cash value of the policy and causing your policy to lapse. If this occurs, you will almost certainly owe taxes on the amount borrowed.

Insurance companies typically offer numerous options for keeping the loan current and preventing it from lapse. If the loan is not repaid before the insured person's death, the loan amount plus any interest owed is deducted from the amount set aside for the beneficiaries from the death benefit.

The Bottom Line

In addition to the death benefit, permanent life insurance with a cash value can provide certain living benefits. Among these are the ability to borrow against the policy's cash value and make cash value withdrawals. When you take out 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 money from the policy. This means that the policy's cash value can continue to grow—but you should check with your insurance company to see how interest and dividends will be calculated and paid while you have an active loan.

Policy loans can be beneficial financial tools, but they can also cause financial distress. If you do not pay your interest, your policy may lapse and the entire loan amount may become taxable. If you die, the loan amount and any interest owed will be deducted from your death benefit, which could have a significant impact on your beneficiaries. Before taking out a life insurance policy loan, carefully consider the pros and cons in the context of your situation.