Are life insurance loans a bad idea?
Key takeaways
- Only permanent life insurance policies, such as whole and universal life, offer loan options — term policies do not.
- Life insurance loans allow policyholders to access cash value without surrendering the policy.
- Life insurance loan interest rates are typically lower than other personal loans, often between 5 and 8 percent.
- Borrowing against your life insurance policy reduces the death benefit, so it’s important to weigh the potential impact on your beneficiaries.
Life insurance loans can be confusing for many people, and it’s not unusual to feel unsure about how they really work. On the surface, borrowing against your life insurance might seem like a convenient way to access funds, especially when you’ve built up cash value in a permanent policy. But there’s more to it than meets the eye. Taking out a loan against your policy comes with tradeoffs, including the risk of reducing your death benefit if the loan isn’t repaid. To help make sense of it all, we’ll break down the ins and outs of life insurance loans so you can weigh the pros and cons and decide if it’s the right move for you.
How do life insurance policy loans work?
There’s a lot of confusion surrounding how life insurance loans work, and a recent Reddit thread highlights many of the misconceptions people have.
“I’ve heard that some people are able to borrower against their whole life insurance policy in the form of a credit line.
Once you open a $1,000,000 whole life insurance policy, how long do you have to wait before being able to obtain a credit line leveraging the whole life insurance policy?”
—Reddit user – Sept. 18, 2024
One common misunderstanding is that policyholders think they can borrow against the death benefit, which is the full amount their beneficiaries would receive. However, this is not accurate. Borrowing is only possible against the net cash surrender value, which is the portion of your permanent life insurance policy that builds up over time.
Another point of uncertainty is how quickly you can access this cash value. Some users in the thread believed they could borrow against their policy almost immediately. The truth is that it often takes several years for the cash value to accumulate enough for borrowing. In the early years, your paid premiums haven’t added up to much yet. Additionally, a large portion of your premium goes toward the cost of insurance, and during the early years, surrender charges are very high, so there’s little cash value available to tap into.
Now that we know a few misconceptions, what are the truths?
- Cash value vs. death benefit: You can only borrow against the cash surrender value of your policy, not the face value or death benefit. The cash value grows over time, typically taking several years to build up enough for borrowing.
- Loan amount: Insurers usually allow you to borrow up to 90 to 95 percent of the cash value. Keep in mind that taking out a loan reduces the total cash value available in the policy, which can impact the amount left to your beneficiaries. A large loan may also erode the policy’s value and cause it to terminate.
- Interest and risk: Loans accrue interest, and if left unchecked, the interest can grow large enough to exceed your cash value, potentially leading to policy termination. Managing the loan balance is crucial to keeping your coverage intact.
- Multiple loans: Policyholders can take out more than one loan as long as there is sufficient cash value available. However, managing multiple loans requires careful oversight to avoid a ballooning loan balance.
The difference between loans and withdrawals
Another sticking point is the difference between loans, withdrawals and surrenders when it comes to life insurance policies. A recent Reddit post highlights this mix-up.
“Hello I’ve had a Variable Universal Life policy with Lincoln since 2019. Before that, I had a policy with Mass Mutual.
I have enough cash accumulated to pay for the new car I’d like to buy. I can surrender (take it out) or borrow it. My head thinks that the loan is a better option because I’d be paying it back to the policy. I spoke with an insurance agent friend to see of this makes sense, but he came up with more questions than answers and didn’t truly give me a yes/no answer.
Does it make sense, is it wise, should I, use this money for the car purchase? The policy is for a large amount, so if my kids or wife get $45k or 50k less when that time comes, I’m not worried about it. I will call Lincoln to ask, but I’m not sure if they’ll give me a clear answer. Thank you”
—Reddit user – Sept. 18, 2024
The poster mentions wanting to use the cash value in their variable universal life policy to buy a car but seems unclear on whether to take a loan or “surrender” the policy — though what they actually seem to be referring to is a withdrawal. This is an important distinction because each option impacts your policy in different ways.
The poster suggests that taking out money for the car may reduce the death benefit by $40,000 to $50,000. While that’s technically possible if they opt for a withdrawal instead of a loan, the loan option they’re considering will accrue interest if not paid back. Over time, the interest will accumulate and can significantly reduce the death benefit by much more than $40,000 or $50,000.
Now that we’ve seen some of the confusion, let’s clear up the differences.
- Loans: When you take a loan from your life insurance policy, you’re borrowing against the cash value. This means the cash value remains intact while the insurer lends you the money, using the policy as collateral. You can repay the loan over time, but if it’s left unpaid, the interest accrues and reduces the death benefit. Over time, if the loan and interest grow too large, they could exceed the cash value and cause the policy to lapse.
- Withdrawals: A withdrawal means you’re permanently taking money from your policy’s cash value. Unlike a loan, this amount isn’t repaid. However, the amount you withdraw is directly subtracted from your cash value and death benefit. While you don’t have to worry about accruing interest, your beneficiaries will receive a reduced payout when you pass away. In the Reddit post, the user refers to this as a “surrender,” but a withdrawal is simply removing a portion of your cash value, not the whole policy.
- Surrender: Surrendering a policy is when you cancel the life insurance policy altogether and take the surrender cash value. This terminates the policy, and there’s no death benefit left for your beneficiaries. While surrendering gives you access to the full cash value (minus any loan balances), it ends your coverage permanently. Depending on your policy, surrender charges may also apply, especially if it’s within the first few years of the policy.
How do I take a loan from my life insurance policy?
To take a loan from your life insurance policy, you need to have the right type of policy — only permanent life insurance policies offer the ability to borrow against their cash value. This includes whole life, universal life, indexed universal life and variable life insurance policies, each of which builds cash value over time. However, the cash value growth rate and borrowing flexibility vary depending on the type of policy.
- Whole life insurance: This policy offers a fixed premium and a guaranteed death benefit. The cash value builds at a steady, minimum guaranteed rate, providing more predictability in terms of growth.
- Universal life insurance (UL): This option offers more flexibility by allowing you to adjust your premium and death benefit. The cash value grows based on the insurer’s declared interest rate, but you can also reduce or increase your premiums based on your financial situation.
- Indexed universal life (IUL): This version of UL ties cash value growth to the performance of a market index, like the S&P 500. While it offers the potential for higher growth, it’s also subject to market volatility and return caps.
- Variable universal life (VUL): Similar to IUL, a VUL lets you invest your cash value in various investment options, like stock funds, bond funds and treasury or money market funds. This offers higher potential returns but with increased risk, as the cash value fluctuates based on your portfolio’s performance.
Once your policy has built up sufficient cash value, you can take out a loan against it. There’s no need for credit checks or a lengthy application process, which makes borrowing from your life insurance policy pretty straightforward. You simply request a loan amount, and the insurer sets the interest rate and creates the loan for you. However, there are no fixed repayment terms.
While you don’t have to repay the loan, it’s a good idea to do so. If left unpaid, the loan accrues interest, and if the loan balance grows too large, it can reduce the death benefit or even cause the policy to lapse. So, while life insurance loans offer flexibility, they also come with risks if not properly managed.
Do life insurance policy loans have to be paid back?
Yes, life insurance policy loans generally need to be paid back, though there is some flexibility in how repayment may occur. Policyholders are generally expected to repay the loan principal and interest during their lifetime. This allows the full death benefit to remain intact for beneficiaries.
If you don’t pay back a life insurance loan and the combined loan and interest exceed the death benefit amount, it could cause the policy to lapse without any payout to beneficiaries. The unpaid amount will be deducted from the death benefit payout when the policyholder passes away, technically “repaying” the loan by reducing what beneficiaries receive.
The pros and cons of life insurance loans
Life insurance loans offer an intriguing way to access funds, but they’re not without their trade-offs. While they allow policyholders to borrow money with relatively modest interest rates and no credit checks, the decision to take out a loan against your policy requires careful consideration. These loans directly impact the cash value and, if not repaid, can reduce the death benefit your loved ones receive. With this in mind, it’s important to evaluate both the advantages and potential downsides of life insurance loans before jumping in.
It may also be worth considering alternatives, such as personal savings or low-interest personal loans, which don’t put your life insurance policy or your beneficiaries’ financial security at risk. Consulting a financial professional can help you determine if borrowing against your life insurance is the right choice for your situation.
| Pros | Cons |
|---|---|
| Loans are tax-free up to your cost basis: You can borrow against your policy’s cash value tax-free as long as you stay within your cost basis. | Cash value takes several years to accumulate: It can take years before your policy builds enough cash value to borrow from, especially in the early stages. |
| No lengthy approval process: There’s no credit check or approval process. You can access the cash value even with poor or no credit history. | Death benefit could be reduced: If the loan isn’t repaid, the outstanding balance will reduce the death benefit your beneficiaries receive. Compounding interest may balloon the loan balance and cause the policy to lapse, leaving you without coverage. |
| No set payment terms: You’re not required to make regular payments. Repayment can be made at your discretion — monthly, quarterly or not at all. You can even opt to only pay back interest but not the principal. | Interest accrues and compounds: Interest on the loan accrues and can compound, increasing the loan balance over time if left unpaid. |
| Loans don’t appear on your credit report: Life insurance loans aren’t reported to credit bureaus, so they won’t impact your credit score. | Potential income tax liability if policy lapses: If your policy lapses and the loan balance exceeds the cost basis, you may face an income tax bill. |
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