How Can I Borrow Money From My Life Insurance Policy?

Life insurance is an important tool that helps you protect your loved ones from financial distress if you die.

There are also advantages to life insurance beyond the death benefit. If you have a policy with a cash value component, you can borrow money from your life insurance. Cash value life insurance can be one of the most convenient, low-cost financing options out there. But there are also pitfalls to avoid if you go this route.

What Types of Life Insurance Policies Can You Borrow From?

Most permanent life insurance policies offer the opportunity to borrow money from the cash value.

Permanent life insurance (including whole life, universal life and variable life) is designed to provide coverage for your lifetime.

Permanent life policies build cash value as you pay the premiums. The cash value portion of the policy either earns interest or is tied to an investment account or index, allowing you to grow the money over time.

Term life insurance, by comparison, is not life insurance you can borrow from. Term life insurance is a fairly low-cost insurance option designed to protect people during the years they need it most, such as the working years until their mortgage is paid off. These policies do not have a cash value component.

How Does a Life Insurance Policy Loan Work?

Policy loans come in the form of direct loans or indirect automatic premium loans, according to Barry Flagg, founder of Veralytic, an independent life insurance analytics company.

Direct loans

With a direct loan, you essentially borrow money from yourself, with the policy’s cash value serving as collateral. For this reason, you don’t have to pay income tax on the money you take out. The insurance company will also charge interest (called a spread).

Flagg explains that you essentially pay the interest back to yourself, less a spread charged by the insurance company. Usually, this can be as little as 0.25% (even 0% in some cases) or as much as 2%.

“Choosing a policy with a low loan spread can make a big difference,” Flagg says. “Either way, policy loans reduce both the policy account value and the death benefit by the amount of the loan on a dollar-for-dollar basis.”

If you pay the policy loan before you pass away, there is no deduction from the death benefit.

Automatic premium loans

An automatic premium loan (APL) allows the insurer to use your cash value to pay your life insurance premiums, if you don’t.

“While insurers generally send notice of such automatic premium loans, consumers don’t often understand the implications,” Flagg says. “So this type of policy loan can unwittingly accumulate for years.”

Flagg says that interest is also added to the balance, often at unfavorable rates. So when policyholders aren’t aware of these implications, APLs can grow quite large, eroding the cash value and causing a policy lapse.

How Does a Life Insurance Loan Affect Your Policy?

Before taking out a policy loan, contact your insurance company to find out how the loan will affect the components of your policy. You can do this by requesting an in-force policy illustration, which shows how the policy’s performance will be impacted if you borrow money, pay back the loan or maintain the loan.

The in-force illustration should also show whether interest is paid out of pocket or borrowed. The insurance company will either charge interest in advance (up front for the full year) or in arrears (at the end of the policy year).

How Much Money Can You Borrow Against a Life Insurance Policy?

Loans are available on life insurance policies when there is enough cash value. The amount you can borrow is represented as a percentage of the cash value. Each life insurance company has rules about how much policyholders can borrow, but Flagg says it’s usually around 90% to 95%.

Using those percentages, if your policy cash value is $50,000, you may be able to borrow $45,000 to $47,500.

How Do You Pay Back a Life Insurance Loan?

Unlike most types of loans, life insurance policy loans don’t have a specified repayment period. You can take as long as you please.

There can be negative consequences, however, for keeping the funds indefinitely because interest accumulates. That’s why if you borrow against your policy, it’s a good idea to pay the loan back in a timely manner.

Policy loans can be repaid in one of three ways.

Cash

Ideally, you would repay your loan with cash payments to the life insurance company. “Repaying in cash increases both the policy account value and the death benefit by the amount of the repayment on a dollar-for-dollar basis,” Flagg says.

Policy value

Flagg says that if costs being charged in a policy can be reduced, and the cash value is then more than enough to cover reduced costs, a policy loan can be repaid with “excess” cash value. He warns, however, that if the amount of the loan repayment is greater than the amount of the policy cost/tax basis, then repaying this way can trigger a taxable event.

Death benefit

If your policy loan balance is still outstanding when you die, the loan balance will be deducted from the death benefit. Your beneficiaries will receive a reduced benefit. Even so, Flagg says that because death benefits are received tax-free, repaying policy loans this way is the most tax-efficient means of repayment (versus repaying with cash that has already been taxed or a withdrawal of excess cash value that could be taxed).

What Happens if You Can’t Pay Back a Life Insurance Loan?

If you don’t repay your policy loan or make payments toward the interest, the interest will compound and be added to the balance. If this goes on for long enough, the amount borrowed could exceed the policy’s cash value, which would cause the policy to lapse.

“Then the full amount of the loan becomes taxable as phantom income,” Flagg says, which he explains is taxable income with no actual cash income to pay the tax. The loan balance is also taxed at ordinary income rates instead of more favorable capital gains tax rates.

If you die before repaying the loan balance, the insurance company will deduct it from your death benefit. So your beneficiaries will receive less and essentially repay the loan on your behalf.

Pros and Cons of Borrowing Money from Life Insurance

Before borrowing money from your life insurance policy, consider these pros and cons.

Pros

• No credit check required: Since you are borrowing your own money, there is no formal credit check needed to qualify for a policy loan.
• Low interest rate: Policy loans are a low-interest financing option. Interest rates range between about 5% to 8%, depending on whether they are fixed or variable.
• Pay it back when you want: There is no formal repayment timeline, so you can make payments toward the balance as it fits your budget and cash flow.
• Cash value keeps growing: Your policy’s cash value simply serves as collateral, so the funds continue to sit in your policy and gain interest.

Cons

• Minimum cash value required: You need to have sufficient cash value before you can take a loan. So if your policy is fairly new, it could take years to build up a decent cash value amount.
• Borrowing amount limited: You can only borrow up to a certain percentage of your cash value. So if you need to borrow more, you may have to explore other (potentially more expensive) financing options.
• Reduced death benefit: If you don’t pay your loan back before you die, it will be deducted from your beneficiary’s death benefit.
• Risk of lapse: Even though you don’t have to pay your loan back according to a set schedule, interest will continue to accrue and the insurer will still make charges for policy expenses. If the balance of your loan grows past the policy’s cash value, the policy could lapse. This would mean you’d have to make an infusion of premium money to keep it in force.

Alternatives to Borrowing Money from a Life Insurance Policy

When done correctly, a life insurance policy loan can be a convenient, low-interest way to borrow money. However, if you want to avoid the risks associated with borrowing from your life insurance, consider these other ways to leverage the cash value.

Withdrawal of cash value

Instead of borrowing money from your life insurance, you can simply withdraw cash from it. As long as you withdraw only up to the amount you’ve paid in premiums so far, you won’t have to pay taxes on the funds. The downside is that a withdrawal will generally reduce your death benefit.

Surrender of policy

If you no longer need life insurance, one option is to surrender your life insurance policy for cash. This can be a good option if you no longer have dependent children or a large amount of debt and need cash for your retirement. Keep in mind that some policies charge surrender fees, reducing the amount you receive.

Casey Bond, Contributor | Ashlee Tilford, Editor