Key takeaways
- Borrowing is only available on permanent life insurance policies, such as whole or universal life, not on term policies.
- Borrowing from your life insurance policy requires no credit checks or approvals, making it simple and hassle-free.
- If not paid off, interest will accumulate over time, and any unpaid loan balance, including interest, will reduce your policy’s death benefit.
- Keep an eye on your loan balance — if it exceeds your policy’s cash value, your coverage will almost certainly lapse, leaving you without life insurance and a potential tax bill.
Life insurance is often thought of as a safety net for your loved ones after you’re gone, but did you know that certain types of life insurance can provide financial benefits while you’re still living? Borrowing against your life insurance policy allows you to access funds when you need them, using the cash value that builds up over time. It can be an appealing option in situations where you want to avoid taking on traditional loans or dipping into your savings.
At Bankrate, we help break down the ins and outs of life insurance policies to give you the information you need to make informed financial decisions. In this article, we’ll walk you through how to borrow from life insurance, what to consider before doing so and how it might impact your long-term goals. Whether you’re looking to cover an emergency expense or fund a major life event, understanding how life insurance loans work can open up new financial possibilities.
Can I borrow from my life insurance policy?
Yes, you can borrow against your life insurance policy — but only if it has a cash value component. Think of it as giving yourself a loan from the value you’ve built up over time. However, don’t expect instant access to those funds. For most policies, surrender charges exist during the first 10 to 15 years, slowly declining. Policy loans can only be taken out from the surrender value and not the accumulated value. So, it takes a few years for that cash value to grow enough to borrow against unless you have something like a single-premium policy, where you make a hefty one-time payment and start building cash value immediately, or a limited-pay policy, which lets you pay off the policy within a set number of years, helping you build up cash value faster.
Here’s a breakdown of the most common types of policies that let you borrow against your cash value:
It’s important to remember, though, that borrowing from your policy isn’t without risks. If you don’t pay the loan back, it’ll be deducted from your death benefit. Worse yet, if the cash value dips too low and the loan remains unpaid, your policy could lapse, leaving you without coverage and potentially a phantom income tax gain. So while borrowing against your life insurance can be a financial lifesaver, it’s important to tread carefully and know all the details beforehand.
What is phantom income?
In the context of life insurance, phantom income is money that the policyholder may be on the hook for paying income tax if they don’t pay back a policy loan, as this is considered canceled debt. For example, let’s say a policyholder wants to surrender their policy for the cash surrender value (CSV) of $100,000, but they have an outstanding loan of $80,000. They have paid $30,000 in premiums — this is their cost basis. Tax law states that you need to pay income taxes on any withdrawals that exceed the cost basis. So, the policy owner would need to include $70,000 as taxable income on their tax return. However, in this scenario, there is also a policy loan to consider. Before the insurance company pays the policyholder a CSV check, the policy owner needs to decide whether or not to repay the loan. If they opt not to, in the end, the policyholder only receives $20,000, yet still owes taxes on the total of $70,000 — the phantom income being $50,000 which is the portion of the policy loan, i.e., canceled debt, that exceeded their cost basis.
Advantages of borrowing from your life insurance policy
Borrowing against your life insurance policy comes with some pretty unique perks. Not only does it give you access to funds when you need them, but it also offers flexibility that traditional loans just can’t compete with. Here are some standout advantages that might make you think twice before heading to the bank:
- No red tape, just cash: Forget about long applications and approvals — with a life insurance loan, there’s no credit check or invasive process. If your policy has enough cash value, you simply request the loan, and you’re good to go. No stressful waiting, just fast access to the money you need.
- Your loan, your rules: Need funds for a surprise home repair or maybe a dream vacation? You can use the money however you like. And unlike traditional loans, you don’t need to justify your spending to anyone. It’s your policy, and how you use the cash is entirely up to you.
- Unseen and unheard: Unlike bank loans, life insurance loans fly completely under the radar. No need to worry about credit scores taking a hit because these loans aren’t reported to credit agencies or the government. It’s a completely private transaction between you and your insurer.
- Repayment? Only if you want to: With a life insurance loan, there’s no pressure to pay it back right away. In fact, repayment isn’t required during your lifetime. If you prefer, you can just pay the interest so the loan doesn’t eat into your cash value. If you choose not to repay the loan, the outstanding balance will simply be deducted from the death benefit before your beneficiaries are paid.
- No risk to your assets: Unlike traditional loans where you might have to put your house or car on the line, borrowing from your life insurance policy only affects the policy itself. If you don’t repay the loan, the worst that happens is a reduced death benefit — and in some cases, a tax bill — leaving you with no need to worry about losing your home or other assets.
These advantages give life insurance loans flexibility and ease you won’t find with more traditional lending options. It could be a smart move when you need financial support without the hassle.
While borrowing cash from your policy can be convenient with minimal red tape, you could be taking future financial security from your loved ones.
Disadvantages of taking a loan out on life insurance
While borrowing from your life insurance policy has its perks, it’s not without some serious caveats. Before you decide to tap into your policy’s cash value, here are a few disadvantages to consider because not all that glitters is gold:
- Interest, the silent drainer: Just like any other loan, interest accumulates over time. If left unchecked, the interest could eventually drain your policy’s cash value. And here’s the kicker, if the cash value runs out, your policy could lapse, leaving you without coverage and potentially facing some hefty tax penalties.
- Bye-bye, cash value growth: Borrowing against your life insurance policy might slow down how quickly your cash value grows. Depending on the type of policy you have, taking out a loan will usually reduce the amount credited to your cash value or dividends, slowing down the steady accumulation you’ve been building. It’s like taking one step forward and two steps back when it comes to growing that nest egg.
- Shrinking death benefit: One of the most significant downsides to borrowing from your policy is that it reduces the death benefit if the loan isn’t repaid. The longer the loan lingers, the more it chips away at what your beneficiaries will receive. In short, you could be borrowing future financial security from your loved ones.
- Rider reductions: If your policy includes any special features, like an accelerated death benefit rider (which allows you to access funds early in cases of terminal illness), borrowing from the policy may reduce the amount available for these benefits. The more you borrow, the less there is for other policy perks.
So, while borrowing against your life insurance policy can be a handy tool, it’s important to consider these potential downsides. Make sure you’re not trading short-term financial relief for long-term coverage loss.
How to borrow from your life insurance policy
Taking out a loan from your life insurance policy isn’t complicated — in fact, it’s one of the more straightforward financial moves you can make. You don’t need to jump through hoops, apply for approval or wait on a credit check. If your policy has built up enough cash value, the process is as simple as making a request.
Here’s how borrowing works:
You’ll reach out to your agent or insurance company, fill out a basic form, and, if your cash value is sufficient, the funds will be on their way to you in just a few business days. No long waits, no stressful approval process. It’s your money, and it’s ready when you need it.
When it comes to interest, it depends on the specifics of your policy. Some policies will lock you in with a fixed rate, while others might adjust based on market indexes. Either way, the interest starts accruing immediately, so it’s always important to be mindful of that, especially if you’re planning to take your time with repayment.
The process is almost too easy, but remember, just because the cash is accessible doesn’t mean it’s free money. Borrowing from your policy can have long-term effects, so it’s worth weighing your options and thinking about the future before you take the leap.
Frequently asked questions
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