Borrowing From Life Insurance: How It Works & When to Borrow

Did you know borrowing from life insurance is possible if you have a whole or universal policy? You can take loans against these two policies specifically because they accrue cash value separate from the death benefit – the tax-free payout beneficiaries receive when the insured dies. 

Taking out a policy loan is simple. There are very few requirements. While borrowing from life insurance is a wise option for some people, it’s not always recommended. Let’s explore how policy loans work, how to get one, and when it’s a good idea. 

Table of Contents

• Can You Borrow Against Your Life Insurance Policy?
• How a Policy Loan Works
• Why Borrow From Life Insurance
• When Should You Borrow Against Life Insurance?
• How to Borrow Against Your Life Insurance
• Alternatives to Borrowing From Life Insurance

Perform an annual policy review to make sure you life insurance continues to meet your needs as the years go by.

Can You Borrow Against Life Insurance?

You can only borrow from permanent life insurance policies, such as whole and universal life insurance. What makes them unique? These policies have a built-in accumulation element called cash value.

Whole and universal life insurance premiums are much higher than term life insurance, but a portion of each premium goes into a separate cash value account.

Each time you pay one of these premiums, the cost covers more than your insurance protection alone. Those excess funds go into the cash value account and earn interest.

This account is separate from the death benefit. Once it has built enough value, you can borrow against it.

It’s a common misconception that your cash value increases your death benefit. With most policies, this isn’t true. You also cannot borrow from the death benefit.

How a Policy Loan Works

Life insurance policy loans are different from traditional bank loans in many ways. Still, they’re all built on the same underlying principle: the borrower is expected to pay the lender back with interest.

Aside from the basic framework, policy loans and bank loans operate on separate sets of rules.

When Can I Take Out a Policy Loan?

You can take a loan from your cash value life insurance policy as soon as there is enough to borrow against. It takes a few years to build value unless you’re overfunding the policy or own a single-pay policy. Account growth also depends on the interest rate it earns.

Whole life insurance has a modest, guaranteed fixed interest rate. The cash value grows slowly and steadily. The interest rates on universal life insurance products, however, fluctuate depending on the market.

How Much Can I Borrow?

Your cash value account balance determines how much you can borrow– typically, as much or as little as you want. You can also take out more than one loan if the amount borrowed doesn’t exceed your total cash value.

How Does Policy Loan Repayment Work?

Unlike traditional loans, there are no mandatory repayment schedules with policy loans. You don’t need to pay it back while you’re alive if you don’t want to.

However, it’s not a free loan. The balance accumulates interest.

There are two different ways to set the loan interest rate. A policy will either have a fixed rate specified in the policy (e.g., 8%) or a variable interest rate tied to the market. Regardless, rates are typically lower than any bank loan or credit card interest rate.

When you take a loan against your policy, the carrier funds the loan and uses your cash value as collateral. If you don’t repay the loan while you’re alive, the unpaid balance plus accumulated interest will be taken from your death benefit, ultimately reducing the money your beneficiaries receive.

In most cases, paying back the loan on top of your regular premiums is advisable to ensure your debt doesn’t grow beyond your control. Alternatively, some people just repay the accruing interest to keep the balance manageable.

How policy loans work:

• Part of each premium funds a separate account that grows due to compounding interest
• Carriers use the account’s cash value as loan collateral
• If you fail to repay the loan, the balance will be taken from the death benefit

Which Type of Life Insurance Can You Borrow From?

You can’t borrow from term life insurance because it doesn’t build cash value. Permanent life insurance policies such as whole and universal build cash value, which means you can borrow from them. What does each policy provide?

• Whole Life Insurance: The most well-known type of permanent life insurance. It offers fixed premiums and guaranteed cash value.
• Universal Life (UL) Insurance: It offers flexible premiums and death benefits but has fewer guarantees. Also allows for cash value withdrawals.

Dive deeper into the differences between whole and universal life insurance. 

Why Borrow From Life Insurance?

Borrowing from your life insurance policy has advantages over getting a loan from the bank or taking on credit card debt.

Pros:

• 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
• The IRS doesn’t recognize policy loans, so they’re free from income tax
• Interest rates on policy loans are typically lower than bank loans
• There is no mandatory repayment plan

As with all loans, there are also consequences to be aware of.

Cons:

• If you don’t repay the policy loan while alive, the balance will be taken from your death benefit
• Interest accrues as long as there is a balance
• If your loan balance and accruing interest ever exceed the cash value, the policy lapses
• May owe taxes if policy lapses
• Loans can reduce your policy’s dividends
• If a UL policy, taking out a loan may negatively impact certain policy guarantees

When Should You Borrow Against Life Insurance?

Before you take out a policy loan, be sure to thoroughly consider all options before doing so. If your main reason for buying life insurance is to ensure your family receives a death benefit, it’s best to leave the cash value untouched. If you take out a loan and don’t pay it back, you can lose your policy and rack up tax penalties, putting your family’s financial security at risk, which defeats the purpose of getting life insurance in the first place.

That said, there are some situations where it’s beneficial to borrow from life insurance, including:

• If you have poor credit or have been turned down for a bank loan: If you have a life insurance policy that builds cash value, you’re automatically approved for a loan. In addition, policy loans don’t require a hard credit check that will further damage your credit.
• You have other, higher interest debts: Policy loan interest rates are often lower than credit cards or bank loans.
• Your family doesn’t need your death benefit: If you’re older with financially independent adult children, you may find a policy loan offers more value than leaving money to your heirs.

Common reasons people take out a policy loan include the following:

• Paying for a child’s wedding
• Paying for a child’s college tuition
• Funding a down payment on a mortgage
• Paying for an emergency expense
• Taking advantage of a business opportunity
• Supplementing retirement income

How to Borrow Against Life Insurance

Taking out a life insurance policy loan is simple. There is no approval process, just a few quick steps.

1. Contact your Quotacy agent.
2. They will locate your insurer’s form for you to complete. 
3. Submit the form.
4. You’ll see the money deposited into your account in a short time. 

Alternatives to Borrowing From Life Insurance

Policy loans aren’t the only way to access your cash value account funds. Instead of borrowing, you can simply make a withdrawal, use your cash value to pay your premiums, or surrender your policy in exchange for a payout.

Withdrawal

In addition to the option to take out policy loans, universal life insurance policies also have a withdrawal option. A withdrawal is a permanent reduction from the policy’s cash value and death benefit. There is no option to pay it back.

You can make a tax-free withdrawal up to the total amount paid into the policy thus far. Any amount over this can be taxed.

Use Cash Value to Pay Premiums

Some cash value products, like universal life insurance, allow you to take money from the cash value account to pay the premiums.

However, with a whole life insurance policy, you can opt for automatic premium payment via a policy loan if you forget to send in payment. This option is called an automatic policy loan.

Cash Surrender Value

If you no longer need life insurance, you can terminate a permanent policy in exchange for its surrender value. This payout, the cash surrender value, is your policy’s total cash value minus termination fees.

This may be a worthwhile option if your beneficiaries don’t need the death benefit and your policy is mature enough to have accrued meaningful value.

Read this article to learn more about cash value accumulation: What Is Cash Value Life Insurance?

Contact a Quotacy Agent to Learn More About Policy Loans

If your family doesn’t need your death benefit or you can’t get a traditional loan, borrowing from a whole or universal life insurance policy may be helpful. For more information about permanent life insurance pricing and options, complete our short questionnaire and an agent will contact you.