Life insurance policy loans: Are they right for you?

Life insurance policy loans can be an opportune way to access the cash value of a life insurance policy while the policyholder is still alive. They’re a “no-questions-asked” way to borrow cash for a variety of purposes, and the ease of borrowing can offer advantages over credit card or other types of personal loans. But life insurance policy loans can inadvertently defeat the purpose of your life insurance — to provide necessary financial support for your family when there’s an unexpected death and loss of income.

How does a life insurance policy loan work?

A life insurance policy loan is basically a loan provided by your insurance carrier using the cash value and death benefit of your life insurance policy as collateral. Payment options include periodic payments of principal and interest, payments of interest only, or deducting ongoing interest from the cash value in the policy. Loan amounts outstanding at the time of the insured’s death are deducted from the death benefit and remaining funds are distributed to the beneficiaries.

Applying for a life insurance policy loan is relatively simple; to qualify, you must have sufficient cash value in your policy and submit a company-specific request form. The amount you can borrow depends on the policy’s terms and conditions and can often be up to 95% of the policy’s cash value.

A life insurance policy loan requires a permanent life insurance policy — usually a whole life or universal life policy — versus a term policy. For more information about the types of life insurance policies, read our article “Life insurance policies: What’s the difference between term vs. permanent?”

Variable and fixed-rate life insurance policy loans

Insurance companies charge interest on a policy loan based on either a fixed or variable rate, depending on the type of policy.

With a variable loan, the policy owner borrows at a floating interest rate that’s determined by the insurance company and occasionally adjusted. The insurance company simultaneously credits the policy with a benchmarked dividend, which is interest earned on the capital previously paid into the policy. With the variable loan interest rate fluctuating year to year, the policy has the potential to outperform the variable interest charge making repayments cheaper. It also has the potential to underperform the loan interest rate resulting in a negative impact.

A fixed life insurance policy loan has a fixed interest rate that’s guaranteed and doesn’t change over the life of the loan. The rate is declared in advance, making the loan’s total interest straightforward to calculate at loan inception. A fixed-interest loan may be the better option if certainty and stability is preferred over potential savings because interest rate fluctuations or market volatility won’t affect the loan. The downside to a fixed-rate loan is that, depending on the market conditions or the performance of the policy’s investments, it may result in a higher interest rate than a variable policy loan. That would mean more interest may be paid over time and, if interest payments are made out of cash value, there will be less cash value and death benefit will be remaining in the policy.

Potential benefits to life insurance policy loans

Life insurance loans can have certain benefits over other types of personal loans. They include:

• No credit check or approval process, so access to the cash is easy. 
• The funds can be used for any purpose.
• The loans often have more favorable interest rates than a traditional bank loan.
• Your money stays in the insurance policy continuing to earn interest.
• There’s no repayment schedule or repayment date. In fact, you don’t have to repay it at all as long as the policy has sufficient cash value.
• If the policy remains in force and the loan is still outstanding at death, it’s not taxable.

Possible downsides to life insurance policy loans

The interplay of factors in a life insurance policy loan can be complex. Here are some things to watch for when considering a loan.

• The assumptions used in your loan and prevailing market conditions can work in your favor, but they can also put the policy in danger of being underwater without you realizing it.
• If the loan is still outstanding at the time of the policyholder’s death, the death benefit will be used to pay back the loan, leaving a reduced death benefit to the beneficiary. 
• Policy dividends have the potential to change over time affecting the amount of money in your policy that’s eligible to borrow.
• If added interest increases the loan value beyond the cash value of your insurance, your policy could be terminated by the insurance company.
• If the policy lapses or is terminated by the insurance company before repayment of the amount owed on the loan, the outstanding loan amount would count as a withdrawal and you could face income tax on the cash value received beyond the premiums paid. A lapse or termination would also result in loss of coverage for your beneficiaries.

Life insurance policy loan best practices

Policy loans can be a valuable feature within a life insurance policy, and a properly constructed loan can give you access to cash values without sacrificing the policy or the death benefits needed by your beneficiaries. But it’s important to understand that the loan could be chipping away at your cash value, and loan interest could be accruing without you realizing it’s happening or how it affects the policy. Here are some best practices to prevent that from happening.

• Understand the available options upfront: When taking out the loan, it’s important to consider and understand the available loan options to determine which is best for your situation. Given the complexities and potential for misunderstanding, you may want to seek a second opinion before moving forward with a life insurance policy loan.
• Consider the alternatives to a life insurance loan: A life insurance policy loan may be a good choice in an emergency, particularly if tapping money from a 401(k) or an annuity could incur excessive cost or penalties. But using the loan for college funding or retirement funds may not be the best answer. In many cases, there’s a superior investment vehicle for these purposes. Your financial advisor can help you work through the alternatives.
• Be clear on the assumptions underlying the loan: The insurance agent writing the loan may use aggressive assumptions and/or draw your attention to the most favorable interest rate and life expectancy inputs. But people are living longer and the investment climate fluctuates, so the inputs used on the loan may not hold out over time. It’s important to consider the full range of potential outcomes, and this is especially so on index or variable policies where the interest rates aren’t guaranteed.
• Understand the potential for adverse tax implications: A loan can create a future tax liability in the event of a policy lapse or termination. It’s important to understand how loan balance and policy values can adversely affect your policy and the tax implications if the policy loan’s assumptions don’t work out. Given the potential for catastrophic consequences, you should consult with a financial advisor or a tax professional before making any decision that affects your life insurance policy.
• Have a plan for repayment: Even though repayment isn’t required on a life insurance policy loan, it’s often best to make repayments to ensure your policy performs as you intend and to ensure sufficient money is available if your beneficiaries need it. If your loan balance is high, it’s advisable to at least make annual interest payments.
• Monitor your loan balance: Review your loan balance at regular intervals to ensure the loan is operating as expected and the policy isn’t in danger of lapsing.
• Review your life insurance policy loan annually: Things can change quickly. Your life insurance policy loan should be reviewed annually with your advisor.

Focus on the fundamentals

A life insurance policy loan can be a useful tool in the right circumstances, but it can get out of control without you realizing it. When considering a loan, keep in mind these three important factors:

• The primary purpose of life insurance is to provide financial security to your beneficiaries after your death. If a life insurance policy loan can compromise that goal, it may be best to explore other sources of cash.
• Before you sign the loan documents, be comfortable with the assumptions that your loan is based on and ensure you understand the full range of possibilities that can occur during the lifetime of the loan.
• Loans can span a long period of time — often beyond the career span of a single life insurance agent. Choose an insurance provider that has the continuity to provide annual reviews and unbiased support over the lifetime of the loan and life insurance policy.

Follow these best practices before you take out a life insurance policy loan — it will be well worth the time.