A policyloan, issued by an insurance company, uses the cash value of a life insurance policy as collateral. Also called a "life insurance loan," it often has lower interest rates than a personal loan and you can use the money for any purpose. You don't need to repay this loan before you die. But there are also downsides to consider.
Key Takeaways
- Policy loans provide a source of funds that use your policy's cash value as collateral.
- You must have accumulated cash value in a permanent life insurance policy to get a policy loan.
- Options for repaying your loan include paying only the annual interest or making periodic payments.
- You don't need to pay back a policy loan before you die, but a loan balance will reduce the death benefit.
How a Policy Loan Works
A policy loan allows you to access the cash value of a lifeinsurance policy using the cash value as collateral. You can usually borrow a certain percentage of the cash value and use the money as you'd like. You won't need to repay this loan before you die. If you don't repay the loan with interest, the death benefit will be reduced.
You can accumulate a cash value with permanent life insurance, coverage that can last your entire life. If a permanent policy has cash value, it is invested and can be used for loans and withdrawals. A cash value component isn't available with term life insurance, which only covers a specific time period.
As cash value builds in a permanent life insurancepolicy, you can borrow theaccumulated fundswithout taxation, as long as you keep your policy in force. If you cancel the policy or it lapses, the outstanding loan counts as a withdrawal. You would then owe income tax on any cash value received beyond what you paid in premiums. You get your premium payments back tax-free.
Funds for a loan from apermanent life insurance policy are availableaccording to the insurer's terms, such as after 10 years. Insurershave varying requirements on how much cash value must accumulate before a policy is eligibleand what percentage can be lent.
With a policy loan, you’re not withdrawing the cash value. You are using it as collateral on a loan that can accumulate interest.
Pros and Cons of a Policy Loan
Getting a policy loan is usually quick and easy. You don’t have to go through an approval process, because you are borrowing against your own assets. You can use the funds in any way you wish.
Another advantage of a policy loan is that the funds aren't taxable as long as you keep your policy in-force.
Also, policy loans don’t have a repayment schedule or repayment date. In fact, you don’t have to pay it back at all. However, if the loan isn't paid before death, the insurance company will reduce the face amount of the insurance policy by what is still owed when the death benefit is paid.
Payback options include periodic payments of principal with annual payments of interest, paying annual interest only, or deducting interest from the cash value.
If a policy loan isn’t repaid,interest can cut into thedeath benefit, which canputthe policy at risk of not providing any money tobeneficiaries. Consider making at least theinterest paymentsso the policy loan doesn’t grow beyond your cash value.
If added interest increases the loan value beyond the cash value of your insurance, your life insurance policy could lapse and be terminated by the insurance company. In such a case, the outstanding policy loan balance can be considered taxable income by the IRS, and the bill could be significant. You owe income tax on any amount you receive in cash value over what you paid in total premiums.
How Much Can You Borrow From an Insurance Policy?
The amount you can borrow from your insurance policy is set by your insurer. Generally it's no more than a certain percentage of your policy's cash value, such as up to 90%.
What Are the Downsides of a Policy Loan?
If a policy loan isn’t repaid, unpaid principal andinterest can cut into thedeath benefit, which canputthe policy at risk of not providing sufficient money or any money at all tobeneficiaries.
What Are a Few Benefits of a Policy Loan?
Policy loans offer easy access to cash for those with permanent life insurance policies. Borrowers don’t have to go through the usual approval process because they are borrowing against their own assets. The funds can be used for any purpose, and they aren't taxable as long as the the policy stays in-force, Borrowers don't have a repayment schedule or repayment date.
The Bottom Line
A policy loan can be a useful tool to provide financing for major expenses, but there are downsides to consider as well. If you are think about taking out a policy loan, you might want to consult with a financial advisor who can explain how it would fit into your overall long-term financial plan.
