How Can I Get a Life Insurance Loan?­­­­­

Life insurance comes in all shapes and sizes. For example, term life insurance policies offer a death benefit only, and permanent life insurance -- like whole or universal life -- allow you to borrow against your life insurance policy. Here, we'll outline how these loans work to help you decide whether life insurance loans are a good idea for you.

One thing some permanent life insurance policies offer is the ability to build cash value, and later, to borrow against that cash. Each time the insured individual makes a premium payment on permanent life insurance, such as a whole life policy, part of the premium goes toward building up cash value.

One of the most common questions policyholders have is "How soon can I borrow against my life insurance policy?" Although it can take years to build up enough to borrow, the answer depends on the company. The insurer determines when a person has enough cash to take out a life insurance loan, and how long the policy must be in effect before that day arrives.

Taking out a loan

Once a person decides that borrowing against life insurance makes sense, the cash they've built up acts as loan collateral. The rules vary by insurer, but a person can usually borrow between 90% and 95% of the cash value of their life insurance policy. Loan funds typically arrive within one to 15 days. 

Let's say a person has been paying on their life insurance policy for 10 years and has built up $100,000 in cash value. That means their insurer may allow them to borrow between $90,000 and $95,000.   

Since policyholders are borrowing against their own money, there's no loan application to fill out, and no credit check to run. But, like kicking the tires on a car before getting down to the nitty-gritty, there is work to be done. The first step is to request an "in-force illustration" from the life insurance company. 

In a nutshell, an in-force illustration is a play-by-play of how that particular life insurance loan works. Whether it's a universal or whole life policy, every policy has its own rules regarding loans.

For example, an in-force illustration specifies whether interest is due in advance or arrears (whether interest is tacked on upfront or at the end of the year). It also outlines how interest accumulates. Typically, it's daily -- another critical fact worth knowing due to how quickly daily accrued interest adds up. An in-force illustration also tells the policyholder whether the interest rate is fixed or variable, meaning whether the rate remains the same or changes periodically.

Borrowing against life insurance is nothing like taking out a standard loan. Even though policyholders are borrowing against money they've accrued, they still pay interest on the loan.  The amount of interest varies by the insurance company. For example, in June 2020, when interest rates for consumer purchases were near rock bottom, the interest rates on cash-value loans from insurance companies ranged from 5% to 8%, which might beat the rate on a traditional personal loan.

Still, before borrowing money, it makes sense to compare life insurance loans with other loan types. It's possible that the best loan option has nothing to do with life insurance.

The borrower can repay the loan in a single payment, in installments, or not at all. Whatever they decide, it may change the death benefit, or even cancel the policy. They can pay interest, or have interest payments withdrawn from funds remaining in the policy's cash reserves. Here's an illustration of how it might work for three different borrowers:

Can you borrow from life insurance? Yes. Should you borrow from life insurance? The answer depends on how much borrowing against life insurance will cost.

In short, a policyholder who takes a loan on a life insurance policy and repays it quickly enough to avoid interest charges may be okay. But a policyholder who takes cash out of a life insurance policy without a plan may learn that life insurance loans can ultimately be more expensive than expected.

Life insurance loan terms vary dramatically by company and policy type. When borrowing against life insurance, it's important to examine the downsides. For example, here are three of the financial consequences of borrowing from a life insurance policy.

1. Compounding debt

The way interest works can be a bit tricky with a life insurance loan. Let's say a policyholder takes out a loan for $25,000 at an interest rate of 8%. Interest in the first year amounts to $2,000. The policyholder can either pay the $2,000 out of pocket (along with a payment toward the principal if they would like) or pay the $2,000 from the cash value remaining in their policy. If they choose to take the funds from the cash value, that amount is added to their total debt, so now they owe $27,000. The following year, they owe interest on $27,000, which adds another $2,160 to the debt, and so on.

There's a bit of "babysitting" involved once a policyholder borrows against life insurance, especially if they're allowing interest to build. At some point, they may take out more cash than they have available in their policy, and the policy will lapse. If the policy lapses and is canceled, they lose everything they've paid in, no longer have the death benefit to leave to heirs, and are likely to owe taxes on the cash withdrawn.

2. Tax implications

As long as a policy is active, the accrued funds are not taxable. However, it's considered a taxable gain when the policy's cash surrender value amounts to more than the premiums paid.

Here's a simplified example: Say someone pays on a policy for 20 years, and the cash value grows to $23,000. They borrow 85% of the cash value, or $19,550. They hit a rough spot and stop making premium payments. At first, the insurance company accesses the remaining $3,450 in cash value to cover the premiums. Once those funds are gone, they cancel the policy. The IRS then says the policyholder owes taxes on the difference between the cash value that was in the account ($23,000) and the total they paid over the years in premiums ($20,000), and sends them a bill for $3,000.

3. Changes to death benefits

Any unpaid portion of a life insurance loan when the policyholder dies is deducted from the death benefit. For example, if someone dies owing $60,000 on a life insurance policy worth $500,000, the beneficiaries receive $440,000.

An interesting note about permanent life insurance and death benefits is that insurance companies "absorb" any cash value accumulated. Let's say a person has a $500,000 policy that has built up $50,000 in cash value. When they die, their beneficiaries receive $500,000, but the insurance company pockets the $50,000. The only workaround is if the insured purchased a special rider that gives the cash value to the estate.

Like all financial decisions, there is no one-size-fits-all answer. Here's a peek at both sides of the coin:

When a life insurance loan might make sense

A life insurance loan could make sense if:

• The policyholder has a financial emergency, but their credit score is too low for a personal loan.
• The policyholder is in over their head with high-interest debt, and uses the life insurance loan to pay off the debt. They must then have the discipline to pay off the life insurance loan unless they're willing to have it deducted from the face value of their policy when they die. In any case, they must make sure the loan balance never exceeds the cash left in their account.
• The policyholder has a windfall coming soon. Say someone inherited a farm and knows for sure that they will have the cash to pay the insurance loan off in full once the farm is sold.

When a life insurance loan is a bad idea

Like most things in life, there's also a flip side. Here's when taking out a life insurance loan is a bad idea:

• The policyholder has never learned to manage debt and is at risk of allowing the policy to be canceled.
• The policyholder does not need the funds to cover a "life or death" expense and can take the time to save money instead.

In many cases, a life insurance loan is not the only option. Here are a couple of other ideas.

Surrender the policy

Each policy has a cash surrender value, an amount of cash the life insurance carrier will pay if the policyholder decides to cancel (or "surrender") the policy. If someone no longer needs the death benefit associated with the policy, it could make sense to surrender it.

Borrow the funds

If policyholders find themselves in dire financial straits, they can look into more traditional ways to get money. For example, if their credit score is high enough, they may land a lower interest rate with a personal loan or line of credit. If their credit score is low, their best bet may be a personal loan from friends or family, as long as they are careful to repay as promised.

Once a person uses a life insurance loan calculator to figure out how much life insurance they need, the real work begins. The next step is to figure out which type of insurance they want to buy. Do they want an inexpensive term life policy that protects their family if they die, or do they want a (far) more expensive permanent life policy that may allow them to borrow against accrued money?

One final note: Because insurance can be such a good financial investment, there are companies that offer to buy policies. If a policyholder ever runs into someone asking them to sell their life insurance policy, they should just say no. These companies prey on the vulnerable and pay pennies on the dollar. There are better ways to get money, like taking out a credit card with a 0% promotional rate. Another option is a low-interest personal loan.