Loan on a Life Insurance Policy

A policy loan, 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.

How a Policy Loan Works

A policy loan allows you to access the cash value of a life insurance 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 insurance policy, you can borrow the accumulated funds without 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 a permanent life insurance policy are available according to the insurer's terms, such as after 10 years. Insurers have varying requirements on how much cash value must accumulate before a policy is eligible and what percentage can be lent.

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.

If a policy loan isn’t repaid, interest can cut into the death benefit, which can put the policy at risk of not providing any money to beneficiaries. Consider making at least the interest payments so 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.

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.