Borrowing against your life insurance policy

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Can you borrow from your life insurance policy? For those in need of an influx of cash who do not want to take out a regular bank loan, the equity built up in a permanent life insurance policy may look very appealing.

However, a loan against a life insurance policy may not be the best financial choice, depending on several factors.

Can you borrow from your policy?

The first question is whether the life insurance policy allows for borrowing. Term life insurance policies do not have any cash value from which to borrow. A term policy has only one financial consideration—the death benefit that beneficiaries receive if the insured person dies during the policy term.

Permanent life insurance, such as whole life, is another story. Some premium payments go toward the death benefit with these policies, but the policy also builds a cash value over time that can be borrowed against when a certain level of value is built.

It is not actually borrowing from the cash value of the death benefit, though. The insurer uses this money as collateral for a loan.

And there is a catch: if the loan, which includes an interest rate set by the insurer, is not paid back, the loan amount could be deducted from the death benefit, and the policy itself could lapse if enough money is taken out and not repaid.

When you should borrow from your life insurance policy

Borrowing money from a life insurance policy makes sense in some circumstances. Since it entails borrowing against the insured person’s resources, there is no hard credit check, so there is no impact on the borrower’s credit rating. For those with poor credit, this may be one way to secure a loan.

Those who would rather not put resources such as their home up as collateral to secure a loan may also prefer to take out a loan from a life insurance policy. When someone’s home is used as collateral and they default on the loan, they stand to lose their house. If the collateral is the policy, the worst that could happen would be that the life insurance policy would lapse, which could be a more attractive option.

It also makes sense to borrow from a life insurance policy once the death benefit has become less important. For example, a widower in their 70s with grown and financially independent children may find a policy loan has more value than leaving money to their heirs.

Disadvantages of taking a loan out on life insurance

It’s always important to think carefully before borrowing against a life insurance policy’s value.

Keep in mind that the policy’s value can’t be used as collateral until it has built up over time. The amount available to borrow for the first few years is negligible, and it usually takes a decade or so to build up enough reserves to make it worthwhile.

The biggest drawback to borrowing may be the risk of losing the policy and incurring tax penalties if the loan is not paid back on time, with interest. If payments on the loan stop, the insurer will instead take the money directly from the policy’s death benefit, cash value or dividends, if those are included.

That may not be a problem in the short term, but if the policy’s value is used up to repay the loan, the policy will lapse. At that point, the policy’s former value, which was borrowed against, will be considered taxable income by the IRS.

Other benefits may also lapse when a loan is taken. For example, for those who have an accelerated benefit rider, which allows the insured person to use a portion of their death benefits for care if they become terminally ill, the amount borrowed may be deducted from the amount available for that purpose.

How to borrow from your life insurance policy

Taking a loan out on life insurance is fairly straightforward. The first step is to determine whether the life insurance policy is one of several types of permanent policies that are eligible for borrowing, including:

  • Whole life (also called ordinary life)
  • Universal or adjustable life
  • Variable life
  • Variable universal life

Unlike a bank loan, there is no approval process to earn a loan against a life insurance policy. It may also be possible to take the loan as a cash surrender value line of credit to be drawn from as needed.

Interest on the loan will begin to accrue immediately, at a rate determined by the insurer which may be lower than the rate a bank would charge. In the best-case scenario, the loan repayment will begin immediately, usually monthly.

Frequently asked questions

What is the best life insurance company?

Since everyone has unique needs, there is no one-size-fits-all when it comes to life insurance. It’s usually a good idea to shop around and speak with a licensed insurance agent to determine the best company and policy. These are currently some of the best companies in the industry.

I have a 20-year life insurance policy. Can I borrow against it?

If the policy has a set term during which it is active, it is considered term life insurance, which has no cash value. Only whole life insurance policies earn cash value in addition to the death benefit, which can be used as collateral for a loan.

What happens if I do not repay my life insurance loan?

In the short-term, not much, since the insurance carrier can use dividends or other policy assets to pay back the amount owed. In the long-term, however, the policy could lapse, and the borrower could face tax penalties.

Is it worth it to have a permanent life insurance policy if I know I’m going to need a loan?

Many insurance experts recommend considering term policies first, but it’s important to speak with a licensed insurance agent to determine what will work best. Term policies cannot be used for a loan, but these policy types are also cheaper than permanent policies, which may help the insured save money and take a smaller loan from another source, such as a bank, instead.

Written by
Mary Van Keuren
Insurance Contributor
Mary Van Keuren has five years of experience writing for insurance domains such as Bankrate.com, Coverage.com and Thesimpledollar.com. She has also written extensively for consumer websites including reviews.com and myslumberyard.com. Prior to that she worked as a writer in academia for several decades.