Borrowing Against Your Life Insurance Policy

Quick answer

• You can borrow against the cash value of permanent life insurance policies (like whole or universal life).
• This is called a policy loan, and it’s not taxed if you repay it.
• Interest accrues on the loan, reducing the death benefit and cash value if not repaid.
• Loans can lapse your policy if the loan balance plus interest exceeds the cash value.
• It’s generally best to consider policy loans as a last resort after exhausting other options.
• Always consult your policy documents and a financial advisor before taking a loan.

What to check first (before you buy or change coverage)

Coverage needs

Before considering any financial product, assess your current and future needs. Life insurance is designed to provide a financial safety net for your beneficiaries. Ensure your current policy’s death benefit is still adequate for your family’s needs, considering inflation and changes in your financial situation. If you’re considering borrowing, it might indicate a need for better financial planning or a review of your insurance coverage.

Deductibles and premiums

When evaluating life insurance, understand the interplay between premiums (what you pay) and deductibles (though life insurance doesn’t have traditional deductibles like health insurance, the concept of what is “covered” is key). For policy loans, the interest rate on the loan is a critical factor. Check your policy’s loan interest rate and how it compounds. Understand that unpaid loan interest can increase the loan balance over time.

Exclusions and limits (general)

Every insurance policy has exclusions – situations where it won’t pay out. For life insurance, these are typically limited (e.g., suicide within the first two years of policy issuance). More importantly for borrowing, understand the loan limits. Your loan amount is restricted by the policy’s accumulated cash value. The total amount you can borrow is usually a percentage of this cash value, as detailed in your policy.

Claim process

While not directly related to borrowing, understanding the claim process is fundamental to life insurance. If you were to pass away with an outstanding policy loan, the loan balance (including accrued interest) would be deducted from the death benefit paid to your beneficiaries. Knowing how claims are handled ensures you understand the ultimate impact of a policy loan on your beneficiaries.

Bundling and discounts (general)

Life insurance policies themselves rarely offer bundling or discounts in the way auto or home insurance might. However, when considering your overall financial picture, explore all avenues for cost savings. If you are struggling to pay premiums and considering a loan, look for ways to reduce overall expenses or increase income first. Sometimes, consolidating or refinancing other debts might free up cash flow, making policy loans unnecessary.

Step-by-step (simple workflow)

Step 1: Review your policy documents

• What to do: Locate your life insurance policy contract and any related loan provisions. Read the sections on cash value, policy loans, and interest rates carefully.
• What “good” looks like: You understand precisely what type of policy you have (e.g., whole life, universal life) and that it has accumulated cash value available for loans. You know the current cash value and the maximum loan amount permitted.
• A common mistake and how to avoid it: Assuming all life insurance policies have cash value. Avoidance: Not all policies, particularly term life insurance, build cash value. If you can’t find information on cash value or loans in your policy, it likely doesn’t have this feature.

Step 2: Determine your borrowing needs

• What to do: Clearly define why you need the funds and how much you need. Assess if this is an emergency or a planned expense.
• What “good” looks like: You have a specific, justifiable reason for needing the money and a clear amount in mind. You’ve considered if other, less impactful financial options exist.
• A common mistake and how to avoid it: Borrowing impulsively for non-essential reasons. Avoidance: Create a budget and a spending plan. If the need isn’t critical, explore other savings or borrowing options first.

Step 3: Contact your insurance provider

• What to do: Call the customer service number for your life insurance company or log into your online account. Inquire about the process for taking a policy loan.
• What “good” looks like: You receive clear instructions on how to apply for a loan, including any required forms or online procedures. You can ask specific questions about interest rates and repayment terms.
• A common mistake and how to avoid it: Not contacting the insurer directly and relying on outdated information. Avoidance: Always get information directly from your insurer to ensure accuracy regarding your specific policy.

Step 4: Understand the loan terms

• What to do: Ask about the current interest rate for policy loans, how it’s calculated, and if it’s fixed or variable. Clarify repayment terms, including whether you must make payments or if interest is simply added to the balance.
• What “good” looks like: You have a clear understanding of the interest rate, how it affects your loan balance, and the flexibility (or lack thereof) in repayment. You know if there are any fees associated with the loan.
• A common mistake and how to avoid it: Not understanding that interest accrues and compounds. Avoidance: Ask specifically about compounding interest and how it can increase your debt over time.

Step 5: Calculate the potential impact on your death benefit

• What to do: Ask your insurer how the loan and any accrued interest will reduce the death benefit paid to your beneficiaries.
• What “good” looks like: You can clearly see the potential reduction in the death benefit based on the loan amount and expected interest growth. This helps you assess the impact on your loved ones.
• A common mistake and how to avoid it: Underestimating how much the loan and interest will reduce the death benefit. Avoidance: Request a projection from your insurer showing the potential death benefit reduction over several years, assuming no repayment.

Step 6: Submit the loan application

• What to do: Complete any required loan application forms or follow the online process provided by your insurer.
• What “good” looks like: The application is submitted accurately and on time, with all necessary documentation.
• A common mistake and how to avoid it: Incomplete or inaccurate applications leading to delays or rejection. Avoidance: Double-check all information before submitting and keep copies for your records.

Step 7: Receive the loan funds

• What to do: Wait for the insurance company to process your loan and disburse the funds. This may be via check or direct deposit.
• What “good” looks like: You receive the loan amount promptly and in the agreed-upon manner.
• A common mistake and how to avoid it: Not having a plan for the funds once received. Avoidance: Have a clear plan for how you will use the money immediately upon receiving it.

Step 8: Plan for repayment

• What to do: Decide on a repayment strategy. This could involve making regular payments, paying interest only, or paying back the principal and interest at a later date.
• What “good” looks like: You have a realistic plan to repay the loan, either through scheduled payments or by setting aside funds. You understand the consequences if you don’t repay.
• A common mistake and how to avoid it: Not having any repayment plan, assuming you can just let it accrue. Avoidance: Treat the policy loan like any other debt. Set a repayment goal and schedule.

Step 9: Monitor your policy and loan balance

• What to do: Regularly check your policy statements and loan balance. Ensure the cash value remains sufficient to cover the loan and any accrued interest.
• What “good” looks like: You are aware of your current loan balance, accrued interest, and remaining cash value, and you can see that your policy is not at risk of lapsing.
• A common mistake and how to avoid it: Forgetting about the loan and letting it grow unchecked. Avoidance: Set reminders to review your policy status at least quarterly.

Step 10: Understand policy lapse risk

• What to do: Be aware that if the loan balance plus accrued interest exceeds the policy’s cash value, the policy can lapse. This means you lose coverage and may owe taxes on the difference between the loan amount and your cost basis.
• What “good” looks like: You understand the conditions under which your policy could lapse and take proactive steps to prevent it.
• A common mistake and how to avoid it: Ignoring the growing loan balance until it’s too late. Avoidance: Always maintain a buffer between your loan balance and your cash value.

Common mistakes (and what happens if you ignore them)

| Mistake | What it causes | Fix