There are two types of life insurance: term life insurance and permanent life insurance. Permanent life insurance is sometimes referred to as cash value life insurance because it accumulates cash value that you can borrow against your life insurance. You cannot borrow against a term life insurance policy.
» Learn more: Term vs Whole Life Insurance
Permanent life insurance has higher premiums than term life insurance because it’s designed to last your entire life and these plans usually have a level premium. This premium is much higher than the actual cost of insurance in the beginning years and these dollars go into a separate account called cash value. Cash values help pay the higher costs of insurance in the plans as we grow older.
In general, the whole life insurance cash values grow by long term investments while universal life’s cash values are more susceptible to interest rate fluctuations.
What Is Cash Value?
Typically, life insurance is for survivors. The cash value component of a life insurance policy provides living benefits for policyowners.
When you die, the life insurance company pays your beneficiaries the death benefit proceeds. However, life insurance policies that grow cash value can be accessed by the policyowner while they are still alive.
If your policy has accumulated cash value, you have the option to withdraw from it or take out a policy loan. A policy loan is different than a policy withdrawal. Each option has pros and cons.
Taking Out a Loan Against Your Life Insurance Policy: Pros and Cons
When you take out a policy loan, it does not automatically reduce your death benefit or cash value. Your policy is collateral for your loan.
If you do not pay back the loan during your lifetime, the insurance company will subtract the amount plus interest (if interest was not paid over the time of the loan) from your policy’s death benefit before paying your beneficiaries.
- Policy loans are approved no questions asked (as long as you have enough cash value)
- Policy loans are confidential and don’t show up on your credit report
- Policy loans are a faster way to receive cash than a bank loan
- Policy loans are not recognized by the IRS and are free from income tax
- Interest rates on policy loans are typically lower than bank loans
- There is no mandatory repayment plan
- The policy loan will need to be repaid or it will be taken from your beneficiary’s proceeds if it’s not paid back during your lifetime
- Interest accrues as long as there is a balance
- If loan balance and accruing interest ever exceeds the cash value, your policy lapses
- May owe taxes if policy lapses
- Loans can reduce your policies dividends
Making Withdrawals from Your Life Insurance Policy: Pros and Cons
Some permanent life insurance products allow you to make partial withdrawals from your policy’s cash value. The amount you have paid into the policy (total premium amount thus far) is the maximum amount you can withdraw tax-free. Any amount over the cumulative premiums can be taxed.
The withdrawal amount is permanently subtracted from the cash value and the death benefit. There is now less cash value left to earn dividends, accumulate, and borrow against. And unlike policy loans, you cannot pay back the withdrawal amount.
- No interest
- Tax-free to a certain amount
- Does not need to be paid back
- Permanently reduces both cash value and death benefit
- Taxable if you take out more than you’ve put in
- Reduces current and future dividends
- Reduction of cash values can ultimately increase your premiums
See what you’d pay for life insurance
Comparison shop prices on custom coverage amounts from the nation’s top carriers with Quotacy.
Should I Borrow Against or Withdraw from My Life Insurance Policy?
It’s best to leave your life insurance policy’s cash value untouched. If you don’t pay attention to the interest accumulation of a policy loan, your policy is at risk for termination. If you don’t pay attention to your withdrawal amounts, you’re at risk for a big tax bill and policy termination. Your family’s financial future may be compromised if you’re not careful.
Plus, if cash values are reduced by loans or withdrawals and the cash value remaining will not be sufficient to pay the higher internal costs of insurance as you get older, the policy owner will either have to pay much higher premiums or the policy will lapse.
Also, some universal life insurance policies have what is called a “secondary guarantee”. This provision guarantees that as long as you pay your planned premium on time and don’t take policy loans or withdrawals, the policy will stay inforce (active) even if all the cash values are used up from expenses and costs of insurance. This provision is very valuable because it guarantees that the premiums on the plan will never rise. If the reason you purchased the plan was to have these secondary guarantees then loans and withdrawals are not an option.
That being said, if you’re in need of cash and other options are not available, your cash value can be a helpful source. Request an inforce illustration from your insurance company first. This will show you the interest rates and how a policy loan will work. It’s possible the interest rates would beat your bank’s loan rates.
Your age and the reason you need the cash can help determine whether a policy loan or withdrawal is better.
Policy Loan or Withdrawal: Which Is Best for Me?
If you’re older and your beneficiaries are no longer financially dependent on you then a policy loan isn’t such a big deal. When you die and the loan balance is taken from the death benefit, it’s not detrimental to your beneficiaries. However, if you’re younger and think you’ll still be around for a while, a withdrawal may be better so there is no interest adding up.
If you have sufficient means to pay off a policy loan in the future, go with the policy loan. If you’re on a limited budget, a withdrawal is probably better.
If the reason you need the cash is a temporary (maybe there is an emergency and you need the money quickly) then a policy loan is probably the better option. Later on you can repay the loan. You don’t want to compromise the cash value accumulation long-term if you can help it.
Reasons why some people may take out a policy loan or withdrawals:
- Paying for a child’s wedding
- Paying for child’s college tuition
- Funding a down payment on a mortgage
- Paying for an emergency expense
- Taking advantage of a business opportunity
- Supplement retirement income
What’s the Point of Having Cash Value?
We’ve been hesitant on promoting taking out loans or withdrawals unless you really need it. So now you may be wondering “What’s the point of my cash value then if I shouldn’t borrow against it or withdraw it?” We’re glad you asked.
Level premiums paid throughout the life of a policy create a cash value fund. The main point behind cash values is that they help pay the increased costs of insurance during the later years. People are at higher risk of dying as they age so the cost of insurance gets higher as we age.
But in addition to this, you can use the cash value in other ways separate from loans and withdrawals. Cash values can be used to pay premiums and used as collateral.
To pay the policy’s premiums, some cash value life insurance products (like universal life insurance) allow you to take money from the cash value account to pay the premiums. With a whole life insurance policy, however, you can set up the policy so premiums are paid automatically via a policy loan if you forget to send in a payment (or choose not to).
I’m cheating a little bit because this second method is actually a loan. You would need to pay the amount back into the policy or it gets taken from the death benefit. It’s just a different setup. However, if you remove cash values and your plan was designed to use them for a level premium, then the policy will either lapse some time in the future or require additional premiums.
Banks love cash value life insurance. If you need a bank loan, many will approve your loan if you put up your life insurance policy as collateral. Your policy’s cash value is not touched unless you fail to pay back the bank loan. Be aware that access to your cash value in the future, once it’s collaterally assigned to the bank, will be limited until the bank is paid back.
If you no longer have a need for your permanent life insurance policy, you can surrender it for the entirety of its cash value. If the policy has been inforce for a long time, the cash value amount could be significant. For retired individuals who no longer have people depending on them financially, the cash surrender value can be a great addition to a retirement fund.
If you’re interested in selling your life insurance policy, check out our blog on the subject: Can I Sell My Life Insurance Policy?
About the writer
Natasha Cornelius, CLU
Senior Editor and Life Insurance Expert
Natasha Cornelius, CLU, is a writer, editor, and life insurance researcher for Quotacy.com where her goal is to make life insurance more transparent and easier to understand. She has been in the life insurance industry since 2010 and has been writing about life insurance since 2014. Natasha earned her Chartered Life Underwriter designation in 2022. She is also co-host of Quotacy’s YouTube series. Connect with her on LinkedIn.