What Is a Life Insurance Loan? How Does It Work?

What is a Life Insurance Loan?

What Is A Life Insurance Loan? How does a life insurance loan work? A life insurance loan when a policy owner takes money out of their policy from the available cash value.  The money is not taken out in a surrender, so it does not permanently reduce the death benefit of the policy.  It must, however, be paid back or the death benefit is reduced by the amount of the outstanding loan when a claim is filed.  While the loan is outstanding, it does accrue interest which adds to the balance of the loan.  If the loan plus the interest accrued becomes too large, it may cause the policy to be surrendered, so it is important to understand and manage your balance.

The Difference Between Loans, Withdrawals, and Surrender

You’ve likely heard of policy withdrawals and surrender. They differ from life insurance loans in a few notable ways.

  • Loans: With a loan, you’re borrowing against the cash value of your policy. 
  • Withdrawals: A withdrawal reduces your policy’s death benefit and cash value. When you make a withdrawal, the cash is subject to taxes if you take out more than you paid in premiums. It also permanently reduces the amount available to you in the future. 
  • Surrender: A full surrender involves canceling your policy in exchange for the surrender or cash value of your policy while a partial surrender is similar to withdrawal, removing some cash, but still keeping your policy in force.

Most policies have a surrender charge for the first 10 to 15 years of the contract. The surrender charge is subtracted from the cash value that is paid to you. 

Types Of Life Insurance That Allow Loans

Any life insurance policy that has a cash value will allow a loan to be taken against that value under normal circumstances (assuming sufficient cash value exists to meet minimum loan requirements).  This means that whole lifeuniversal life, and variable universal life insurance contracts all allow loans to be taken out.  In other words, any permanent life insurance policy.

The type of life insurance that does not allow a loan to be taken out is term life insurance.  Term life insurance has no cash value, and therefore it is impossible to loan against this product type.  Term insurance does not build cash value because it is not a permanent form of life insurance, and it would be unnecessary to have an accruing value as this would add unnecessary additions to premium payments.

How to Request a Loan

A loan is typically a fairly simple to request.  A call to your insurance companies’ customer service line, or to your agent will allow you to request the loan.  You do not usually need to fill out any paperwork, but you may need to sign a form if your company requires it.  Before you request a loan, verify the amount of available cash value and the total balance available for loan.  Make sure you understand the interest rate as well, because it will not be an insignificant percentage.  The loan will be paid either directly into your bank account, or a check will be sent by mail.  You may be able to request expedited shipping if necessary.

Only an owner can request a loan.  If the insured person and the owner are different people, the insured person does not have any rights to the cash in the policy and they can not borrow against the cash or the surrender value of the policy.

Advantages of Life Insurance Loans

Any type of financial vehicle has a potential for great gains along with correlated risks. Borrowing money from your life insurance isn’t any different.

Here are the biggest advantages of taking out a life insurance loan.

1: Competitive Interest Rates: Life insurance loans often beat market rates. We’ve all seen ads for low-interest home and car loans, but average interest rates on personal loans and credit cards start in the double digits. 

2: Flexible Repayment You can repay a life insurance loan on your schedule. When you get the in-force illustration, it’ll show you what happens if you don’t repay the loan and varying repayment schedules. 

3: No Credit Check One of the best parts of a life insurance loan is that it won’t show up on your credit report. The insurer doesn’t care why you want the money. You can use it for anything, like paying down higher-interest debt, funding a vacation, or putting extra cash in retirement. 

4: Opportunity Cost: If you have $10,000 invested in the stock market and sell $2,000 of it, you’re down to $8,000.

If the market grows by 10%, you have $8,800 instead of the $11,000 you could have had if you hadn’t sold the stocks. 

The difference is the opportunity cost. 

Life insurance loans don’t have opportunity cost because you aren’t actually borrowing from your cash value. It keeps growing even as you borrow. 

5: Cash Value Credit Protection: In roughly half of the states, creditors cannot go after your life insurance policy. By extension, they cannot seize the cash value in your life insurance policy. 

Sometimes life happens. In this case, your life insurance’s cash value can be an invaluable safety net to protect your family from vultures. 

Risks of Life Insurance Loans

Life insurance loans do have their risks.

Many can be avoided by careful calculation and research, while others will need to be weighed in relation to the benefits. 

1: Accidental Policy Lapse: If your loan and accrued interest exceeds your policy’s cash value, the policy can lapse. 

If the policy lapses, the loan becomes taxable income. The IRS wants its share of any income, and the moment your loan is no longer a loan, you’ll owe the IRS money. 

2: Banks May Have Lower Interest Rates: Depending on what you’re using the money for, you might get better interest rates by applying for a specific loan. 

While most policies technically allow you to start borrowing against the cash value after a few years, slower growth policies may have little built up until you get a dozen or so years in. 

3: Potential Dividend Reduction: Choosing not to repay the loan can result in the company automatically assigning your dividends to pay off your loan or interest instead of growing your cash value.

This presents problems if you rely on those dividends to increase your cash value and keep your policy in force. 

See Also: What Type Of Life Insurance Pays Dividends?

4: Policy Lapse Risk: When there is no available cash value for the insurance company to hold as collateral against your loan, the policy will lapse. You can run out the cash value by letting the interest grow too much.

For example, say you have a whole life policy that grows 4% every year and your interest is locked at 7%.

Your loan plus interest will eventually catch up to the total cash value if you don’t pay back the loan. 

When the policy lapses, any remaining loan becomes taxable as income.

5: Tax Traps: Loans from your life insurance policy do not incur any taxes. Technically, it’s a loan, so the IRS can’t tax it.

This is great news if you’re using it to supplement your retirement. 

However, the moment your policy lapses (if something goes wrong with the policy mechanics), any outstanding loans from your policy become taxable income.

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