How to Borrow From Life Insurance

by Kevin Mercadante

One of the biggest benefits of having a whole life insurance policy is that it will build up cash value – in addition to your policy’s death benefit. This accumulated cash value enables you to borrow from life insurance without the need to qualify for a loan the way you would have to if you borrow from conventional sources.

Whole life vs. term life

When the topic is borrowing from life insurance, it’s important to stop and make an important distinction. You cannot borrow against a term life insurance policy.

When you have term life, you have pure insurance – there is no cash value accumulation and no investment provision. You’re paying a reduced amount (as compared with whole life and other investment type policies) and you’re getting life insurance coverage, period.

Since the policy does not accumulate cash value, there is no equity in the policy to borrow against. So when we are discussing the ability to borrow from life insurance, if your policy is term, there is no loan provision in your policy.

Neal’s notes. It is true that you can indeed borrow from a whole life policy and you can’t do so with term insurance. But in the battle between term vs whole life, term is still the winner if you ask me. It is so much cheaper and provides so much more coverage. Often, the reason people who own whole life end up needing to borrow is specifically because those whole life premiums are so high in the first place.

How to borrow from life insurance

Your life insurance policy should contain a provision on borrowing against the policy. You should read this provision to make sure that you understand it thoroughly. But understand that the one thing that the policy provisions won’t give you is the amount of money that you are entitled to borrow at any one time.

Another note by Neal – rather than borrow, you can also consider the option of cancelling the whole life policy and replacing it with term….or not if you no longer need the coverage. This could potentially provide the needed cash and get you more insurance at a significantly lower premium.

You’ll be borrowing the cash value of your policy, and that is a number that can rise or fall. It will increase as you make your premiums. It will decrease when ever you take a loan against it, or some have some other form of withdrawal.

You’ll have to check with your insurance carrier to determine exactly what the cash value balance is at any point in time. This will be the maximum amount of money that you’ll be able to borrow from the policy (the insurance company may have a limit on this as well).

You will likely be required to complete some kind of authorization forms, and to provide certain information. Once you do, the loan proceeds will be sent to you, generally by check to the policy holder‘s address of record.

No repayment is necessary

Unlike 401(k) loans, no repayment is required when you borrow from life insurance. However, as the loan is taken against the cash value of the policy, the loan principal – plus any accrued interest – will be subtracted from the proceeds that will be payable to your beneficiaries upon your death.

You can make payments if you wish, in order to restore part or all of your cash value, but it will not be required as part of your loan agreement.

The effect of the loan on your policy

Once you have taken the loan proceeds, the policy will remain essentially the same going forward. Your premium will remain the same (unless you decide to make repayments in addition to the basic premium), and the face amount of your insurance death benefit will be exactly what it was when you began the policy.

However, your cash value will be reduced by the amount of the loan, and that will both restrict your ability to get future loans, as well as reduce the amount of the benefit (the face value of the policy plus the accumulated cash value) that your beneficiaries will receive upon your death.

Risks if you borrow from life insuranceborrow from life insurance

Just like other loan types, there are risks when you borrow from life insurance policies, even though they are different from the risks that you face on other kinds of loans.

If your life insurance policy is a MEC – or modified endowment contract – the loan could create a tax liability. Since life insurance policy cash values represent a tax shelter, the government has limited the amount of money that can be withdrawn from these policies on a tax-free basis. If your insurance policy is considered to be a MEC, you will have to pay tax on some or all of the loan proceeds, and if you are under the age of 59 ½, you may also be subject to a 10% penalty tax.

Is not always possible to know whether or not your policy falls under the MEC provisions, as some policies are reclassified under this category after the fact.

Another potential tax liability can be created if you do not make your premium payments on time and your policy lapses . Under IRS rules, loan proceeds could be taxed as an MEC if the loan has not been repaid prior to your death. This may not be a problem for you as the policy owner, but it would fall on your beneficiaries to settle the tax liability that results from the unpaid loan.

Do you own a whole life policy and if so, have you ever taken out a loan? Did you repay it? How did it ultimately work out for you?

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