Dangers of Policy Loans (2024)

Taking out a loan against your life insurance policy can be an easy way to get cash when you need it. While there are some advantages to policy loans, it is also crucial to be aware of the dangers that come with them. By fully understanding the benefits and drawbacks of policy loans, you'll be able to determine if taking out a life insurance policy loan is your best option.

What is a policy loan?

Your life insurance policy will provide your beneficiaries with a cash payout upon your death. As the policy owner, you pay ongoing premiums, and in return, your loved ones will receive money when you die. The payout, also called the death benefit, can be used for any purpose. A policy loan is a loan taken out against your life insurance policy in an amount that doesn't exceed its cash value.

Policy loans are only available with permanent life insurance policies. Whole life insurance and universal life insurance are both permanent policies that accrue cash value. Term life insurance is temporary and has no cash value. When deciding whether to purchase term vs. whole life insurance, one important consideration is whether you may need access to a policy loan in the future.

As you pay the premiums on a permanent life insurance policy, a portion of the payments goes toward the policy's cash value. The cash value of a life insurance policy accrues interest and grows tax-free. After the cash value reaches a certain amount, you can take out a loan against the life insurance policy, known as a policy loan. It often takes years of paying premiums before life insurance policies have enough cash value to borrow against.

How it works

You'll need to fill out a form with your insurance provider to take out policy loans from life insurance. You can usually find the form on your insurance provider's website or through your insurance agent. Because the cash value of your insurance policy serves as collateral for the loan, the insurance provider will not need to run a credit check, so the process is quick, and you will often have the money within days.

When you take a policy loan, the money doesn't actually come out of your policy. Instead, it comes from the insurance company's general pool of funds, and your policy's cash value is used as collateral. The money in your policy continues to earn interest, but you will also be charged interest on the loan you take out. You won't need to pay taxes on the money you borrow as long as your policy remains active.

There is no repayment schedule for a policy loan, so you can pay back the principal and the accumulated interest however you'd like. If you don't pay the annual interest payments on the loan, the cost of the interest payments will be taken out of your policy.

If the interest on your loan accumulates to the point that the amount of the loan plus interest is greater than the cash value of the policy, the policy will lapse, and you will lose your life insurance coverage. At this point, you will probably have to pay taxes on the loan as it will be treated as income rather than a loan. Once your policy lapses, you will no longer have life insurance coverage in case of death.

Insurers' requirements

The requirements for taking a policy loan vary by insurance provider. Policy loans can only be taken on permanent life insurance policies and only after the policy's cash value accumulates above a certain amount.

Check with your life insurance company to find the minimum cash value you need in your policy before taking out a loan. With most policies, you will need to pay premiums for several years before you can take out a policy loan.

The benefits of policy loans

Policy loans are a quick and easy way to access cash in an emergency. Unlike loans from banks, the money is your own, so the provider won't have to run a credit check, there are no application fees and the approval is almost immediate in most cases. Because there is no credit check, the loan won't affect your credit score. Plus, there are no restrictions on what the money from a policy loan can be used for.

Interest rates on policy loans are often lower than on traditional loans. The loan is also tax-free as long as the policy doesn't lapse. Additionally, depending on what you use the policy loan funds for, interest paid on a policy loan may be tax-deductible.

The drawbacks of policy loans

If you borrow against your life insurance policy and don't make the annual out-of-pocket interest payments, your insurance provider will use your policy balance to pay the interest portion of the loan. When this happens, your policy's death benefit decreases, leaving your loved ones vulnerable if you die before fully repaying the loan.

If the interest accumulates to the point that the loan is larger than the policy's cash value, the policy will no longer be active, and your beneficiaries won't receive any death benefits. In this case, you will usually be responsible for paying income taxes on the loan.

Why borrowers should be wary of policy loans

Policy loans sound almost too good to be true. You get to take out a loan that you can repay however you want. But like most things that sound too good to be true, there are some reasons to be wary of policy loans. Without a set repayment schedule for the loan, it is very easy to put off paying it back. While the interest rates on policy loans are often lower than on traditional loans, interest compounds and accumulates quickly.

If you don't make the annual interest payments on your loan, the interest will be paid using the remaining cash value of the policy as well as the death benefit. Over time, the death benefit will continue to decrease. If the policy lapses, you'll likely owe income taxes on the loan, and your loved ones won't get any financial payout when you die.

Most people take out a life insurance policy to ensure that their loved ones will have some financial security after their death. If this is important to you, taking out a policy loan that you may not be able to pay back is probably not in your best interest, even if it seems like a good idea at the time.

When taking out a policy loan might make sense

Taking out a policy loan might make sense if you need money quickly and you feel confident that you'll be able to fully repay the loan and the accumulated interest within a reasonable period. If a financial emergency arises, a policy loan is often a better option than running up your credit card debt, and it may be better than taking out a personal loan if the interest rate on the policy loan is lower.

If you need money to hold you over while waiting on another form of income to come through, such as a pending insurance payout, taking out a policy loan might make sense. As soon as you receive the other income, you'll be able to pay back your policy loan and fully restore both the cash value and the death benefit of your policy.

Another situation in which taking out a policy loan might make sense is if your beneficiaries are primarily independent and won't be relying on the death benefit of your life insurance to meet their basic needs. For example, if your children are grown and financially secure, having a life insurance policy can still be helpful, but at this point, your need to take out a policy loan may outweigh the risk of them receiving a lower death benefit.

What you should do before taking out a policy loan

Fully understand its potential impact

Before deciding to take out a policy loan, be sure that you understand the potential impact the loan will have on your life insurance policy and your overall financial goals. One of the best ways to understand how a loan will impact your policy is by getting an in-force policy illustration from your insurance agent.

The policy illustration will show you the future value of your policy based on several different scenarios, such as fully paying off the loan, making out-of-pocket payments only on the interest and using your remaining cash value to repay the loan. The policy illustration will help you determine if a policy loan aligns with your financial goals.

Consult a financial advisor

You should speak to a financial advisor when deciding whether to take out a policy loan. They can help you better understand how the loan will impact your financial well-being. Given your financial circ*mstances, they can also explain the tax implications of taking out the loan. This will allow you to make a fully-informed decision.

A financial advisor can help you see the bigger financial picture and present alternatives that better align with your needs and goals. If you ultimately decide to take out a life insurance policy loan, your financial planner can help you arrange a plan to pay back the loan in a way that fits your budget.

Explore other funding options

Before taking out a policy loan, explore any alternative funding options. You won't know if a policy loan is your best option until you know all your options. Talk to your financial institution to find out what interest rates you would pay on a personal loan and compare this to the rate you would pay on your policy loan balance. Determine if there are any funding sources you may be able to access that would charge no or minimal interest.

You should also consider other ways of accessing the cash value of your life insurance policy. You may be able to withdraw cash rather than take it as a loan. This will decrease your policy's death benefit, so be sure you fully understand the implications of withdrawing from your policy before doing so.

Another option, if you're tight on money and considering a policy loan, is to use your cash value to pay your premiums for a period of time. This may free up enough money in your budget so you don't need to take a loan. It will lessen your policy's death benefit but may allow you to keep it active while going through a short-term financial hardship.

Review of Money’s Dangers of Policy Loan

Borrowing against your insurance policy can be helpful when you need funds, but policy loans also carry several risks.

Permanent life insurance such as whole life insurance, universal life insurance and some no-exam life insurance policies accrue cash value as you pay monthly premiums. The minimum amount you need to accrue before taking out a policy loan varies by insurance company. Once you reach the minimum, life insurance companies allow you to borrow up to 90% of the policy’s cash value.

You can use your policy loan for any purpose. These funds are tax-free so long as your policy remains active. Interest rates on policy loans are typically lower than those of credit cards or other kinds of loans. Depending on how you use policy loan funds, you may be able to deduct interest paid on your taxes. (Consult a financial or tax advisor for more information.)

The dangers of policy loans are primarily related to issues with repayment. Collateral for your policy loan is the policy’s cash value, so you mustn’t fall behind on interest payments. If the accrued interest on your loan surpasses the cash value of your policy, the life insurance could deduct what’s owed from your policy’s cash value or even cancel your policy altogether.

Additionally, if you don't repay the loan before your death, the life insurance company will collect that money from the death benefit; your beneficiaries could end up receiving little to zero money from your policy.

The best life insurance companies that accrue cash value offer clear rules for policy loans. If you’re considering a policy loan, ask your agent for guidance first. Ensure you’re making the right choice by evaluating the life insurance company’s policy loan protocol and comparing it with your ability to repay the loan.