Understanding Life Insurance Loans (2024)

If you need money to fund a major expense or necessity, you may be able to turn to your insurance policy. If you have permanent life insurance, which includes whole life, adjustable life, variable life, universal life, and indexed universal life, you'll likely have a cash value component you can access.

Unlike term life insurance, which has a set time limit on its coverage period and does not accumulate cash value, permanent life insurance does have a cash component.

At the beginning of the policy, more of the premium goes toward funding the indemnity benefit. As the policy matures, cash value increases,

When You Can Borrow From a Life Insurance Policy

As cash value builds in a whole or universal life insurance policy, policyholders can borrow against the accumulated funds. Money from life insurance policy loans goes to your bank account tax-free, unless your policy lapses before you repay the loan.

How fast or to what extent the cash value will increase depends on a number of factors, including what kind of policy you have.So, the time when your policy will be eligible for a loan will also vary.

Many policies start accruing cash value in two to five years. That cash value typically will be enough to borrow against in about 10 years, says Richard Reich, president of Intramark Insurance Services, Inc., a life insurance agency in Glendale, Calif. The loan will be funded by the insurance company, and your policy's cash value will be used as collateral, he said.

No Need to Repay

One benefit to taking out loans against your cash value is that you don't have to repay them, however there are some downsides to not repaying the loan.

If you repay all or a portion of the loan, options include periodic payments of principal with annual payments of interest, paying annual interest only, or deducting interest from the cash value. “Loans have an interest rate like any other type of loan," says Reich. Interest will be fixed or variable, depending on your policy.

However, if the loan is not paid back before death, the insurance company will reduce the death benefit, says Ted Bernstein, CEO, Life Insurance Concepts, Inc., a life insurance consulting and auditing firm in Boca Raton, Fla. The accumulated interest can also reduce the benefit.

A reduced benefit can put the policy at risk of not providing beneficiaries sufficient money upon the death of the insured.

When a Loan Makes Sense

A life insurance loan might be a sensible choice in several situations. They include:

You Can’t Qualify for a Standard Loan or Need Cash Now

Because the money is already within the policy and immediately available, a life insurance policy can provide a source of immediate funds for major expenses like a new furnace, medical bills, or emergency costs. No credit check is required as your cash value is used as collateral.

Even if you qualify for a traditional loan from a bank or credit union, a life insurance loan could be a valuable stopgap if you don’t have time to wait as long for your application to be processed. When the traditional loan comes through, you can then use it to repay the life insurance loan.

You Can’t Afford Your Policy’s Annual Premium

Don’t let a life insurance policy lapse because you can’t afford the payment.With a premium loan, the policy can stay in effect as long as the death benefit is greater than the amount of the loan. This is because the value of the death benefit is what would be used to cover the value of the loan in the event it was not repaid.

Your Only Other Loan Options Have Much Higher Interest Rates

Compared to traditional loans, life insurance policy loans can be very competitive, Bernstein says. Other loans, such as personal loan, typically have a higher interest rate. Or, in the case of home equity loans, they may require that you pledge additional collateral.

With life insurance loans, there are no loan terms such as repayment dates, renewal dates, or other fees.

Disadvantages of a Life Insurance Loan

There are also disadvantages to taking out a loan against your life insurance. And while most life insurance with cash values allows for loans, there are terms. For example, you'll have to pay interest (often 5% or 8%) that accrues on a loan. It may be your money in the policy, but you can't borrow it for free.

If you don't pay back the loan (and interest), the death benefit will decrease, and if the interest creeps up and you owe more than you have in your policy, it will lapse. If the policy lapses, the cash you took out, may be treated as income by the IRS, and you may owe taxes on it. Unlike most loans, life insurance loans usually don't have a timeline for repayment, so you must make regular payments to pay down the loan.

How Much Cash Value Can You Take Out of a Whole Life Insurance Policy?

The amount of cash value you can take out of your whole life insurance policy depends on the rules of the insurance company that holds your policy. Usually, if there is accumulated cash value in your policy, you can borrow from it, make withdrawals, or surrender your policy and remove your cash.

When Should You Cash Out a Whole Life Insurance Policy?

If you plan to leave money to your spouse, children, or other beneficiaries through your life insurance policy, you probably don't want to cash it out.

If you find yourself strapped for cash or need money for large medical bills or a financial emergency, you may be tempted to cash out or surrender your policy. You will receive the money you've paid into your policy, plus earned interest.

Taking a loan or withdrawal, however, and leaving some funds in your policy are also options as the policy will remain in effect and you can restore the full death benefit when you repay the loan.

The Bottom Line

A life insurance policy can be a good financial tool for many people, but it's not right for everyone. Whether you need a life insurance policy and what type will depend on your personal financial situation. Similarly, if you have an insurance policy with a cash value, weigh the pros and cons before deciding if that strategy is in your own financial best interest depending on your own situation.