How Can I Borrow Money From My Life Insurance Policy? (2024)

There are advantages to life insurance beyond the death benefit. If you have a policy with a cash value component, you can borrow money from your life insurance. Cash value life insurance can be one of the most convenient, low-cost financing options out there. But there are also pitfalls to avoid if you take out a life insurance loan.

What Is a Life Insurance Policy Loan?

A life insurance policy loan is a loan you can take out against the cash value component of a cash value life insurance policy. Life insurance loans are not the same as other loans: Policy owners are not required to repay the loan. But, the insurance company will charge interest on the policy loan.

How Does a Life Insurance Policy Loan Work?

Policy loans come in the form of direct loans or indirect automatic premium loans, according to Barry D. Flagg, Forbes Advisor advisory board member.

Direct Loans

With a direct loan, you essentially borrow money from yourself, with the policy’s cash value serving as collateral. For this reason, you don’t have to pay income tax on the money you take out. The insurance company will charge interest (called a spread).

Flagg explains that you essentially pay the interest back to yourself, less a spread charged by the insurance company. Usually, this can be as little as 0.25% (even 0% in some cases) or as much as 2%.

“Choosing a policy with a low loan spread can make a big difference,” Flagg says. “Either way, policy loans reduce both the policy account value and the death benefit by the amount of the loan on a dollar-for-dollar basis.”

If you pay the policy loan before you pass away, there is no deduction from the death benefit.

Automatic Premium Loans

An automatic premium loan (APL) allows the insurer to use your cash value to pay your life insurance premiums if you don’t.

“While insurers generally send notice of such automatic premium loans, consumers don’t often understand the implications,” Flagg says. “So this type of policy loan can unwittingly accumulate for years.”

Flagg says that interest is also added to the balance, often at unfavorable rates. So when policyholders aren’t aware of these implications, APLs can grow quite large, eroding the cash value and causing a policy lapse.

What Types of Life Insurance Policies Can You Borrow From?

Most permanent life insurance policies offer the opportunity to borrow money from the cash value.

Permanent life insurance (including whole life, universal life and variable life) is designed to provide coverage for your lifetime.

Permanent life policies build cash value as you pay the premiums. The cash value portion of the policy either earns interest or is tied to an investment account or index, allowing you to grow the money over time.

Term life insurance, by comparison, is not life insurance you can borrow from. Term life insurance is a fairly low-cost option designed to protect people when they need it most, such as the working years until their mortgage is paid off. These policies do not have a cash value component.

How Much Money Can You Borrow Against a Life Insurance Policy?

Loans are available on life insurance policies when there is enough cash value. The amount you can borrow is represented as a percentage of the cash value. Each life insurance company has rules about how much policyholders can borrow, but Flagg says it’s usually around 90% to 95%.

Using those percentages, if your policy cash value is $50,000, you may be able to borrow $45,000 to $47,500.

How to Monitor a Life Insurance Policy Loan

Since the insurance company will not require you to pay back the loan balance, they will not provide a repayment schedule. You have the option each year to pay loan interest out of pocket or borrow the interest. If you choose to borrow the interest, the loan balance will compound, which means the interest due each year will compound.

It’s important to request an in-force policy illustration annually to determine the impact of a policy loan. Your request should include the following scenarios, along with any others that reflect your plans:

• Repaying the policy loan in full
• Paying premiums and interest out of pocket
• Borrowing future premiums and loan interest
• Showing what happens if your current premium payments stay the same
• Showing the premium needed to endow the policy at maturity
• Any other action you’re considering, such as taking a partial withdrawal or changing your dividend option

How Do You Pay Back a Life Insurance Loan?

Policy loans can be repaid in one of three ways.

Cash

Ideally, you would repay your loan with cash payments to the life insurance company. “Repaying in cash increases both the policy account value and the death benefit by the amount of the repayment on a dollar-for-dollar basis,” Flagg says.

Policy Value

Flagg says that if costs being charged in a policy can be reduced, and the cash value is then more than enough to cover reduced costs, a policy loan can be repaid with “excess” cash value. He warns, however, that if the loan repayment amount is greater than the amount of the policy cost/tax basis, then repaying this way can trigger a taxable event.

Death Benefit

If your policy loan balance is still outstanding when you die, the loan balance will be deducted from the death benefit. Your beneficiaries will receive a reduced benefit. Even so, Flagg says that because death benefits are received tax-free, repaying policy loans this way is the most tax-efficient means of repayment (versus repaying with cash that has already been taxed or a withdrawal of excess cash value that could be taxed).

Why Is a Life Insurance Policy Loan Risky?

If you’ve taken out a loan from the cash value, the lower cash value will result in lower earnings. If your premium payments aren’t enough to cover the mortality cost and other fees, the insurer will take it from your cash value. Your cash value is being depleted by multiple demands—the loan, lower earnings and fees. If the cash value goes to zero, the policy will terminate unless you make additional premium payments.

If the policy terminates, you’ll get dinged by an income tax bill on the loan money you took.

Calculating Taxable Income from a Life Insurance Policy Loan

Here’s how to calculate the potential gain in the policy that would be subject to income tax:

1. Add the net cash (surrender) value, any dividends received (prior or accumulated) and the outstanding loan balance.
2. Subtract the cost basis (sum of premiums paid into the policy).

Example: If a life insurance policy terminates with a loan balance of $100,000 and a cost basis of $50,000, the taxable gain would be $50,000.

Please note that the above example is a general rule and may not apply to every situation. You should consult your tax advisor to confirm whether you have a taxable gain.

Your life insurance company will be able to provide you with the cost basis and the gain, which they will report to the Internal Revenue Service as 1099 income.

While a life insurance policy loan can provide you with immediate funds, it can have a number of drawbacks. Know what you’re getting into before you take the cash.

Pros and Cons of Borrowing Money from Life Insurance

Consider these pros and cons before borrowing money from your life insurance policy.

Pros

• No credit check required. Since you are borrowing your own money, no formal credit check is needed to qualify for a policy loan.
• Low interest rate. Policy loans are a low-interest financing option. Interest rates range between about 5% to 8%, depending on whether they are fixed or variable.
• Pay it back when you want. There is no formal repayment timeline, so you can make payments toward the balance as it fits your budget and cash flow.
• Cash value keeps growing. Your policy’s cash value simply serves as collateral, so the funds continue to sit in your policy and gain interest.

Cons

• Minimum cash value required. You need to have sufficient cash value before you can take a loan. So if your policy is fairly new, it could take years to build up a decent cash value amount.
• Borrowing amount limited. You can only borrow up to a certain percentage of your cash value. If you need to borrow more, you may have to explore other (potentially more expensive) financing options.
• Reduced death benefit. If you don’t repay your loan before you die, it will be deducted from your beneficiary’s death benefit.
• Risk of lapse. Even though you don’t have to pay your loan back according to a set schedule, interest will continue to accrue, and the insurer will still make charges for policy expenses. If the balance of your loan grows past the policy’s cash value, the policy could lapse. That would mean you’d have to make an infusion of premium money to keep it in force.