Borrowing from your life insurance policy can be a convenient way to access funds if you need to cover a big expense. Only whole or permanent life insurance policies can be borrowed from; term life insurance policies don’t have a cash value that you can borrow against. We’ll cover how borrowing money from a whole life insurance policy works, how much you can borrow, and what you should consider when borrowing funds from a life insurance policy.
Can you borrow against your life insurance policy?
You can borrow against your life insurance policy only if you have a whole or permanent life insurance policy. This type of policy doesn’t have a fixed term limit, and provides coverage for your entire life as long as you continue to pay your monthly premiums. Whole life insurance policies also accumulate a cash value over time, which earns interest and can be borrowed against while you’re still living. You can borrow from a whole life insurance policy as long as the cash value of the policy is equal to or greater than the amount you intend to withdraw.
It’s not possible to borrow money from a term life insurance policy. This type of life insurance policy is typically more affordable, and covers individuals for a set term length, usually of 10, 20, or 30 years. After the term length is over, the policy expires and individuals must purchase a new policy. Term life insurance doesn’t accumulate a cash value over time.
How much can you borrow from your life insurance policy?
The rules for borrowing from a whole life insurance policy vary from insurer to insurer, but a good general rule of thumb is that you can borrow up to 90% of the cash value of your insurance policy. There’s usually no minimum loan amount, so you can borrow as much or as little as you need, as long as it doesn’t exceed 90% of the cash value.
It’s important to note that, when you take out a life insurance policy loan, you’re not actually withdrawing funds from the cash value of your policy. Instead, you’re borrowing from the insurance company, who uses the cash value of your policy as collateral.
How does a life insurance policy loan work?
Borrowing against your whole or permanent life insurance policy is one way to take advantage of the accumulated cash value of your policy.
How permanent life insurance builds cash value
When you pay the monthly premium for your permanent life insurance policy, the money is divided in three ways: part of the premium goes to your death benefit, which pays out in the event that you pass away; part goes to the cash value of your policy, which earns interest and can be borrowed against while you’re still living; and part goes to the insurance company itself.
As you continue to make monthly payments, the cash value of your insurance policy grows. Depending on the type of permanent life insurance policy that you have, the cash value of your policy may grow according to a guaranteed interest rate, current interest rates, or may be invested and subject to variable rates.
Borrowing against your life insurance policy
Once your policy has accumulated a certain cash value, you may want to borrow against it. This is different from withdrawing funds from your policy directly, since the cash value of your policy remains in your account and continues to earn interest.
To borrow against your policy, you’ll take out what is known as a life insurance policy loan. This loan isn’t classified as income, which means it’s one way to access funds without paying additional income tax. In order to take out this type of loan, you should get in touch with your insurance company.
There’s usually no set term length for paying back a life insurance policy loan. However, the insurance company will charge you interest on the outstanding loan balance until you pay it back. How much interest an insurer can charge is typically subject to state regulations. It’s important to keep in mind that the interest compounds each year, which can dramatically increase your loan balance over time unless it’s paid off.
Pros and cons of taking out a life insurance loan
Taking out a life insurance policy loan is one way to take advantage of the accumulating cash value of your policy, but there are also some downsides to keep in mind. Whether a life insurance policy loan is right for you depends on your own personal financial circumstances.
- Not subject to income tax: The IRS doesn’t classify life insurance policy loans. This means that, unlike funds withdrawn from certain retirement accounts, funds from a life insurance policy loan are tax-free and wont increase the amount of income tax you owe.
- Doesn’t affect your credit score: Unlike many other forms of borrowing, a life insurance policy loan doesn’t affect your credit score, and there’s no credit check required.
- Easy to access: The approval process for a life insurance policy loan is quick and easy, and you can receive funds from the loan in just a few business days.
- No restrictions on spending: There are no restrictions on what you spend the funds from your loan on, so you can use it on whatever you need to, whether that’s to cover an emergency expense, fund college spending, or to use as a down payment on a home.
- Cash value continues to accumulate interest: When you take out a life insurance policy loan, the cash value of your policy continues to accumulate interest.
- Flexible loan amounts and term lengths: You can borrow as much or as little as you need, up to 90% of the cash value of your policy in most cases. Once you’ve taken out a loan, there’s no set repayment schedule, so you can pay it back on your own time.
- Your loan will accumulate interest: The longer you wait to pay back your life insurance policy loan, the more interest will accumulate.
- Reduced death benefit: In some cases, your death benefit will be reduced until you pay back the loan, which could mean that your dependents and other family members will receive less money.
- Dependent on the cash value of your policy: The amount of money that you can borrow is dependent on the cash value of your policy, which grows gradually over time. Especially if you have a newer whole life insurance policy, you may not yet be able to borrow from it, or you may only be able to borrow a modest sum.
- You could owe taxes in the future: If you don’t pay back the amount of your loan, the balance will continue to increase thanks to accumulated interest. If the balance of the loan exceeds the cash value of your policy, your coverage could lapse, and you could owe taxes on the amount you borrowed.
This story was written by NJ Personal Finance, a partner of NJ.com. The information presented here is created independently from the NJ.com editorial staff, and purchases made through links in this article may result in NJ.com earning a commission.
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