How to Borrow From Life Insurance

One of the biggest benefits of having a whole life insurance policy is that it can potentially build up cash value – in addition to the death benefit. If the policy does accumulate cash value you may borrow against it and you may be able to do so tax-free.  If you need that money and the stars align, such a loan could be a cheaper source of capital than other avenues.

Whole life vs. term life

The reason that whole life or universal life insurance provides the potential to borrow is because some of the premium you pay gets invested.  And this differentiates between whole life and term.

Term is much cheaper than whole life because you only pay for the pure insurance.   With whole life, you still pay for the term coverage, but on top of that, you pay more into the policy. That’s why it’s more expensive than term.  This extra amount is the money (and the only money) that grows, depending on expenses and earnings.

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. I would never suggest you buy whole life for the borrowing feature or the investment feature alone.  The expenses are so high and the returns are usually so low that the only people who make out on these deals are the insurance companies and the sales people. 

How to borrow from life insurance

If you are still reading, it probably means you are stuck with a whole life policy and need some bread.  Time to make lemonade out of lemons.

Let’s find out if you can borrow against your policy and if so, how much and how much will it cost.

First step, read through your policy.  It probably has a loan provision which states the terms of any loan you take against the cash value.

Next, contact the insurance company to determine exactly what the cash value balance is, how much they’ll loan you, what the interest rate is and how to get the loan put in place as soon as possible.  Also, confirm that the loan is tax-free.  If not, make sure you understand the exact tax consequences of your actions.   I’ll talk more about that shortly.

Another note by Neal – rather than borrow from your life insurance policy, 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.

Is repayment necessary?

Unlike 401(k) loans or most other loans for that matter, 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.

For example, if your death benefit is $100,000 and you die with an outstanding loan balance of $25,000, your death benefit will be $75,000.

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 as I said above.

Possible tax surprises.  The risk.

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.

Ask your company if the policy is a “MEC” which stands for modified endowment contract.  If it is, you could be setting yourself up for a tax liability if you take a loan against the policy.

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.  That’s why it’s important to confirm this with the company itself.

Another potential tax liability can be created if you do not make your premium payments on time and your policy lapses – that’s a risk whether or not you have a loan against the policy.

Also, under IRS rules, loan proceeds could be taxed as a 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.

All in all, it’s easy to get a loan if you have permanent life insurance with cash value. But that doesn’t mean you should go for it.  There are tax risks to worry about.  Also, if you bought a policy to protect your family with a death benefit, the loan reduces it dollar for dollar (even more when you consider accumulated interest).

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?