You’re only able to take out life insurance loans if you have permanent life insurance, which provides coverage for your entire life and comes with a cash value component that earns interest as long as you’re alive.
Term life insurance, which expires after a set period and has no cash value, does not have a policy loan option.
Key takeaways
You can take a loan against a permanent life insurance policy, but not a term life policy.
Insurers won’t run your credit before approving a loan.
If you don’t make loan payments, your coverage can lapse or the money you owe will be taken out of your death benefit when you die.
Avoid complications and save time by buying a term policy and getting a loan from a traditional lender.
How do life insurance loans work?
After the cash value of your permanent policy reaches a certain amount — the exact minimum varies by insurer — you can take out a loan against your policy.
But life insurance loans come with some stipulations that make them more complex than standard bank loans.
Life insurance loans, also called policy loans, could reduce your policy’s death benefit, leaving your beneficiaries with limited financial support after your death.
Additionally, if you don’t pay off your loan balance, your policy could eventually lapse, and you could even face a large tax burden.
When do life insurance loans make sense?
When you take out a life insurance loan, you’re not actually withdrawing from your life insurance policy. Instead, your insurer extends you the loan, using your cash value as collateral.
“I typically would recommend a client take out a loan against an insurance policy if they are at a point where they no longer need the death benefit to cover the people they initially purchased it for,” says Malcolm Ethridge, executive vice president and financial advisor at CIC Wealth.
“For instance, a retired couple whose home is paid off and children are financially independent likely does not need a large death benefit once they pass away. The same with a widow or widower.”
Life insurance loans are also worth considering if:
You don’t qualify for a standard loan from your bank. The life insurance company won’t run a credit check before offering you a loan. And because there’s no hard inquiry into your credit, applying won’t affect your credit score.
You don’t want to put other assets up as collateral. Some creditors will only extend you a loan if you put up some kind of asset, like your house, as collateral. If you don’t make loan payments, the asset can be repossessed. While you ideally don’t want to lose your coverage, it may be better than losing a different asset.
You want a more flexible repayment schedule. Traditional loans typically have a set repayment schedule. Life insurance loans don’t have a repayment schedule, though not making any payments will eventually result in a loss of coverage.
You can afford to pay back the loan. If you’re confident you can make regular payments toward your debt, a life insurance loan may be a less risky option for your circumstances.
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Why shouldn’t you take out a life insurance loan?
If you can’t repay a life insurance loan, you risk reducing the death benefit or losing your coverage. Much like selling your policy, taking out a loan needs to be considered very carefully before you make the decision.
Your policy could lapse
Life insurance loans have an interest rate set by the insurance company. If you don’t make payments and the interest you owe becomes higher than the amount of cash value in your policy, your coverage will lapse.
If your policy lapses, you could owe taxes
If your coverage lapses, the value of your depleted life insurance will be considered taxable income by the IRS.
For example, say your loan was for $100,000, and it accrued $10,000 in interest during the time your policy’s cash value was keeping your policy in force. When the policy lapses, you could be taxed on the $110,000, minus any payments you made out of pocket.
The death benefit itself isn’t taxed if you paid your premiums with your take-home pay.
Unpaid portions of the loan can also reduce other benefits
When you buy life insurance, you have the option to add an accelerated death benefit rider, which lets you use part of the death benefit to help pay for your care if you become critically ill.
If you have an unpaid policy loan balance, it can reduce the amount you’re allowed to take from the accelerated death benefit.
Additionally, any unpaid loan balance could reduce the amount you’re owed in dividends if you were otherwise eligible to receive any. That means you’ll have less money to withdraw from the policy if you just want straight cash.
You have a variable life insurance policy
Variable life insurance is a type of permanent life insurance in which part of your premiums are placed in an investment account, and your cash value only increases when the return on investment is positive.
When you take out a policy loan using your variable life insurance policy as collateral, you may pay more interest than you would if you had a simple whole life insurance policy.
That’s because you could be charged an opportunity cost, which is the difference between what your premiums were earning while invested and the amount you’re paying the insurer in interest payments.
Alternatives to life insurance loans
If you’re concerned about the potential risks of borrowing against your policy, you might be better off:
Buying term life insurance: Term life insurance is much cheaper than permanent life insurance because it lasts for a limited time and doesn’t have cash value. Permanent life insurance is five to 15 times more expensive than term.
Cashing out your policy: Your insurer may allow you to surrender your policy after it’s been active for a certain number of years. This means canceling your permanent policy, after which you would receive the cash surrender value.
If you’re set on getting a policy loan, you may have the option to get an overloan protection rider. This rider ensures that your policy can’t lapse if you’re unable to repay your loan.
However, the rider doesn’t take effect until age 65 or older and often comes with additional restrictions to qualify.
If you need a loan, it’s less complicated and less risky to apply at a bank or other financial institution than to borrow against your life insurance policy.
Life insurance loans can introduce waiting periods before you’re able to borrow funds, tax implications, and jeopardize the most important benefit of your policy — the payout for your loved ones.
To learn more about life insurance and get answers to your questions, speak to a financial advisor who can help you make the right choice.
Frequently asked questions
Can you borrow against a life insurance policy?
You can borrow against a permanent life insurance policy with a cash value. If you have term life insurance, you can’t take out a life insurance loan.
When can you borrow from your life insurance policy?
After your cash value grows to a certain amount (set by your insurer), you’re eligible for a loan. Terms and interest are set by the insurance company.
What are the pros and cons of borrowing from life insurance?
Policy loans are helpful if you wouldn’t be approved for a loan at another financial institution. It could also help if you don’t want to put other assets, like a house, up as collateral.
However, borrowing comes with tax implications, and failing to repay the loan puts your policy and your beneficiaries at risk.
