If you are looking to borrow against your life insurance you have to ensure that you have the correct type of policy and that your policy has cash surrender value. Once you determine that you have a type of life insurance that permits borrowing and that you have cash value against which you can borrow, you can initiate the life insurance policy loan process or look to use your cash value as collateral with a bank.
Why Type of Policies Allow Borrowing?
Whole life insurance and universal life insurance policies have a policy loan feature. These types of life insurance build cash value through the payment of premiums and you are free to take loans out against that cash value whenever you want to.
Term life insurance does not accumulate cash value and therefore does not permit you to borrow against it. In some cases, you may need a term life death benefit to secure a loan issued by a bank or through a government agency like the Small Business Association (SBA). This is not the same as borrow against a policy.
When Can I take a Loan Against my Policy?
Generally speaking, you can take a loan against a life insurance policy as soon as you have cash surrender value. Some companies require you to wait for a specified time period after policy issue before taking a loan. For example, you may need to wait for one year after starting a new policy before taking your first loan.
What Happens when you Borrow Against a Life Insurance Policy?
When you borrow against a life insurance policy, you are technically pledging the cash value in the policy as collateral for a loan issued by the insurance company. The cash in your life insurance policy does not come out of the policy. This cash value will continue to earn guaranteed interest under the contract and in most cases some degree of non-guaranteed dividend or interest (depending on the type of life insurance policy).
Earning a non-guaranteed dividend or interest with an outstanding loan depends on the life insurance company/contract features. For whole life insurance policies, non-guaranteed earnings with an outstanding loan depend on the dividend recognition policy at the life insurance company. For universal life insurance, there is much more variability and non-guaranteed earnings with an outstanding loan are contract specific.
The loan issued by the insurance company will accrue interest. You will have the option to pay this interest out-of-pocket or add it to the outstanding loan balance. The loan balance will reduce both the available cash value and outstanding death benefit of the policy. If you cancel your policy with an outstanding loan, the insurance company will deduct the loan balance from your cash surrender value and pay you the remainder. If you die with a loan outstanding, the insurance company will deduct the loan balance from the death benefit and pay the remainder to your beneficiary.
How Much Can I Borrow from My Life Insurance Policy?
The maximum borrowable amount depends on company policy, the loan interest rate, and the guaranteed interest accumulation rate of the policy. As a rule-of-thumb, most insurers allow policy owners to borrow between 90 and 95% of the net cash surrender value of a policy.
This number may vary considerably with some types of indexed universal life insurance using systematic allocation features such as dollar-cost-averaging accounts when selecting a specific type of loan that allows the cash pledged for the loan to continue earning indexed interest credits.
Can I Take Money out of My Life Insurance?
For most life insurance policies that accumulate cash value, you do have the option to take this money out of the policy without canceling the policy. But there are specific rules you should understand.
Remove cash value from a policy is different from borrowing against your policy's cash value. In this case, you are removing the cash from the policy. There is no loan involved, so there is no loan interest accruing. But, you also forfeit any guaranteed and non-guaranteed (if applicable) earnings on the money you remove.
Once removed, you rarely have the option to put the money back into the policy, so you should take time to weigh your options and ensure that you truly never wish to benefit from having the money in the policy in the future.
Removing money from a life insurance policy can affect the death benefit more dramatically than you might anticipate. This is especially true of whole life policies. Often removing money from a whole life policy will result in a reduction of death benefit that is larger than the sum of the money removed. This is due to the way policy owners remove cash value from a whole life policy through the surrender of paid-up additions.
Should I Take a Loan or Withdrawal from Life Insurance Cash Value?
The decision to use a policy loan or withdrawal is dependent on circumstances. Your specific needs will dictate the correct course of action. You can use the following as extremely general advice to act as a starting point when choosing between the two options.
Loans work best when someone plans to “put the money back into the policy.” While you technically never took the money out, paying off the loan is functionally equivalent to putting it back in. These situations commonly involve temporary needs for cash such as an emergency or an investment opportunity. It's also reasonable to say moderate purchases such as home renovations/upgrades, vacations, and automobile purchases could work with a policy loan (this is a core aspect of the numerous books and systems promoting the idea of self-banking).
In addition, loans become necessary when seeking to use money in a policy with no cost basis. Life insurance policies allow the policy owner to remove cash value in a way that removed cost basis first, which comes with the benefit of being tax-free. But eventually, one can remove all the cost basis in the policy and any withdrawal moving forward is taxable as ordinary income. The way around a taxable distribution once fully removing the cost basis is through a policy loan. Policy loans are always income tax-free provided the policy is not a Modified Endowment Contract.
It's often best to use a withdrawal for cash needs that have an extremely low likelihood of being returned to the policy. The most common use of withdrawals from a life insurance policy comes when one begins using the policy cash value for retirement income. While there are times when loans are still the best bet, the more common approach is taking withdrawals until removing the entire cost basis from the policy.