Life Insurance Loans: Understanding How It Works

Life Insurance Loans
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If you need money to fund a major expense or necessity, you may be able to take a loan out of your life 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.

One of the reasons some people buy cash-value life insurance is the potential to borrow money from the policy later on. When you bought your insurance policy, the insurance agent may have touted that you would be borrowing your own money and paying yourself back.

Insurance agents and companies may promote loans as an easy way to receive tax-free money from your life insurance policy. However, policy loans are more complicated than they appear. While borrowing from your life insurance policy can be a quick and easy way to get cash in hand when you need it, there are a few specifics to know before borrowing.

Most importantly, you can only borrow against a permanent life insurance policy, meaning either a whole life insurance or a universal life insurance policy.

Life insurance policy loans need to be reviewed and monitored. If a policy loan is not monitored, a policy could slowly deteriorate, losing the minimum cash value needed. This can leave you with the unpleasant choice of making substantial loan repayments or having a large phantom income tax gain.

What is a life insurance policy loan?

Policy loans are available on most permanent cash-value life insurance policies. Life insurance policy loans are not the same as other loans: Policy owners are not required to repay the loan. Keep in mind that the insurance company will charge interest on the policy loan.

If you borrow money from your life insurance policy, you are borrowing your own money. It is essentially an advance of money that could be received from the policy either through a surrender of the policy or the payment of the death benefit. It is money that you, or your beneficiary, would have received anyway. The policy’s cash value acts as collateral for the policy loan.

If you never pay back the policy loan during your lifetime, the amount is deducted from the death benefit when you pass away. This means that your beneficiaries will receive less and essentially repay the loan.

How does a life insurance policy loan work?

Life insurance policy loans are available on life insurance policies where there is sufficient cash value to borrow against. (Term life insurance has no cash value.) The available loan amount will be a percentage of the cash value. You must pay interest on the policy loan.

To initiate a policy loan, you’ll need to contact your life insurance company. Before taking out a policy loan, find out what will happen to the components of your policy after the loan. You can do this by requesting an in-force policy illustration that will reflect the policy’s value based on your plans—whether you’ll borrow more money, repay the loan or maintain the loan.

A few things to note:

  • Be sure the in-force illustration also reflects whether you will be paying interest on the loan out of pocket or if you will be borrowing interest as well.
  • Review the following terms of the loan.

The insurance company will charge interest in advance or in arrears.

Interest in advance

Interest in advance means the insurance company charges interest for the full year. This assumes that the loan is continued for that policy year. If the loan is taken out in the middle of a policy year, interest is charged for the remainder of the policy year at the time the loan is taken out.
If a loan repayment is made during the policy year, the insurance company will typically not provide any credit or refund on the interest paid in advance.

Interest in arrears

This means the insurance company charges interest at the end of the policy year. Interest accumulates daily. If a loan is taken out in the middle of a policy year, interest starts to accumulate that day. If you make a loan repayment in the middle of the policy year, this would decrease the daily loan interest amount, thereby decreasing the loan interest due at the end of the policy year.

The interest rate on a life insurance policy loan could be fixed or variable. Fixed interest rates are guaranteed, so you will know in advance what your loan interest will be each year. Variable interest rates can change each year. Variable interest rates will be disclosed on your policy’s annual statement and with premium notices when loan interest is due.

The money you have taken out can still earn gains. The insurance company will pay you interest (or dividends) on the amount borrowed, although this rate is usually lower than the interest rate credited to the remainder of cash value. On certain policies, you will receive the same interest rate.

Whole life insurance policies work by using the term “recognition” to define how much interest is credited to the amount of the cash value that is loaned out. If your life insurance company uses the non-direct recognition method, you will receive the same dividend on your all cash value. If your company uses the direct recognition method, you may receive a lower dividend on the amount of your cash value that constitutes the loan.

Whole-life policies may also have an optional automatic premium loan provision. If you don’t pay your premium due, it is automatically deducted from the cash value through a policy loan.

Keep in mind that interest on a policy loan is generally not tax-deductible.

How do I take a loan from my life insurance policy?

To take a loan from your life insurance policy, you must first have the right type of policy. 

Permanent life insurance policies are the only type of life insurance you can take a loan from. Part of the policy is a cash-value savings account. The insurance company will take a portion of each premium payment and add it to the cash value account. Over time, the cash value will grow, tax-deferred and with interest.

How fast it grows depends on the type of permanent life insurance policy you have:

  • A whole life insurance policy sets a fixed monthly premium over the life of the policy with a guaranteed death benefit. Cash value automatically builds up at a minimum guaranteed rate.
  • A universal life insurance policy offers additional flexibility to have a monthly payment divided into two parts: One covers life insurance and the other goes into savings and investment to help build cash value.
  • A variable universal life policy combines a death benefit with a savings account that allows you to invest in stocks, bonds and other vehicles you choose. You can grow your policy quicker, but also take on the risk that comes along with becoming an investor.

Once you reach a certain cash value balance determined by your insurer, you are eligible to take a loan against it. There are no credit checks or application process to take a life insurance loan. To take one, you request a loan amount from the insurer and the insurer sets up the loan and determines the life insurance loan interest rate. There are no set repayment terms like with a bank loan.

Although you don’t have to pay the loan back, it is wise to do so.

Do life insurance policy loans have to be paid back?

Yes, life insurance policy loans generally need to be paid back, though there is some flexibility in how repayment may occur. Policyholders are generally expected to repay the loan principal and interest during their lifetime. This allows the full death benefit to remain intact for beneficiaries.

If you don’t pay back a life insurance loan and the combined loan and interest exceed the death benefit amount, it could cause the policy to lapse without any payout to beneficiaries. The unpaid amount will typically be deducted from the death benefit payout when the policyholder passes away, technically “repaying” the loan by reducing what beneficiaries receive.

When can you 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.

Insurers have varying rules for how much cash value a policy must have before you can borrow against it and what percentage of cash value you can borrow.

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.

Which policies can you borrow from?

Both whole life and universal life insurance policies are more expensive than term, but have no pre-determined expiration date. If sufficient premiums are paid, the policy is in force for the lifetime of the insured. While the monthly premiums are higher than term, money paid into the policy that exceeds the cost of insurance builds in a cash value account that’s part of the policy.

The purpose of the cash value is to offset the rising cost of insurance as you age. This is so premiums can remain level throughout life and not rise to unaffordable amounts in your later years.

Permanent life insurance has a few important values: the face value, the death benefit (often the same as the face value), and the cash value. One common misconception is that the cash value increases the death benefit. This is only true on certain types of permanent policies; on most policies, it does not increase the death benefit.

Money in the cash value grows at a rate that depends on the type of policy. For example, in a regular universal life policy, it grows based on current interest rates, while in a variable universal life policy, the cash value is invested by the owner in the stock market (and grows accordingly).

It usually takes at least a few years for the cash value to build to sufficient levels to take out a loan.

As for how much you can borrow, each insurance company will have different rules in place. In general, though, the most you can borrow against your life insurance is up to 90% of its cash value.

Paying back the loan

Even with low-interest rates and a flexible payback schedule, it’s important that you pay the loan back in a timely manner—on top of your regular premium payments. If unpaid, interest is added to the balance and accrues, putting your loan at risk of exceeding the policy’s cash value and causing your policy to lapse.

If that happens, it’s likely you’ll owe taxes on the amount you borrowed.

Insurance companies generally provide many opportunities to keep the loan current and prevent lapsing. If the loan is not paid back before the insured person’s death, the loan amount plus any interest owed is subtracted from the amount the beneficiaries are set to receive from the death benefit.

How to monitor a life insurance policy loan

The insurance company will not require you to pay back the loan balance. Nor do they provide any loan repayment schedule. You have the option each year to pay loan interest out of pocket or to borrow the interest. If you choose to borrow the interest, the loan balance will compound, which means that 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:

  • Re-paying 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

Why a life insurance policy loan is risky

An in-force policy illustration can help you determine how long your policy will remain in force while the loan is out. You will find that the larger the loan, the more impact it will have on your policy.

For example, with an initial policy loan of $50,000 and a loan interest rate of 8%:

  • The loan interest in year one will be $4,000.
  • If you borrow the loan interest, your loan balance would increase to $54,000 (initial loan amount of $50,000 plus the loan interest of $4,000).
  • The loan interest in year two would increase to $4,320.
  • The loan balance would increase to $58,320 if the loan interest is borrowed again ($54,000 loan balance plus the loan interest of $4,320).

As you can see, this rapidly increases the policy loan balance.

Here’s how it works:

With a typical permanent life insurance policy, the cash value increases every year. This reduces the total risk to the insurer because it will pay out only the death benefit when you pass away and absorb the cash value. Mortality costs—the actual cost of insurance for you—are also increasing each year because you get older. But that increase is usually offset for the insurer by the decreasing amount at risk.

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. Now 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 an infusion of premium. And once the policy terminates, you’ll get dinged by an income tax bill on the loan money you took.


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