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. Your cash value grows as time goes on, so you likely won’t be able to take out a substantial loan in the first five to 10 years of owning your policy.
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.
When you take out a life insurance loan, you’re not directly withdrawing from your life insurance policy. Instead, your insurer extends you the loan, using your cash value as collateral.
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?
Life insurance loans are 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 could 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.
“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,” says Ethridge. “The same with a widow or widower.”
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 active. 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, too.
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 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: The rates for term life insurance are much cheaper than those for permanent life insurance because it lasts for a limited time and doesn’t have cash value. Permanent life insurance is much more expensive than term.
Cashing out your policy: If you already own a permanent life insurance policy, you can surrender your policy without penalty 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 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.