How Do Life Insurance Policy Loans Work?

Can you borrow against life insurance and how do life insurance policy loans actually work?  For a lot of life insurance policies out there, the answer is yes.

However, there are some types of life insurance that do not permit loans because they do not build cash value.  There are also types of life insurance that technically build cash value and technically permit loans, but I'd strongly caution against using this feature because it forfeits certain other benefits that are likely much more important to the policyholder.

If you are in search of information on borrowing against life insurance, you've come to the right place.  Today I'll detail all the ins and outs of life insurance policy loans.

How Do I Use a Life Insurance Policy Loan?

First and foremost, in order to borrow against a life insurance policy you must have both 1.) a policy that builds cash value and 2.) the policy must have actually built up some cash value.

This seems almost pointlessly straightforward, but I assure you there is a lot of confusion concerning what life insurance policies permit borrowing and what ones do not.

If you happen to own either whole life insurance or universal life insurance (any type of universal life insurance) the answer is yes, you have the ability to borrow against the policy so long as the policy has cash surrender value in it.

If you alternatively own term life insurance the answer is no.  Sorry, but term life insurance does not accumulate cash value and therefore has no feature to allow for a policy loan.

In true Insurance Pro Blog fashion, I'll take a quick moment to make a technical note about this information that might cause some confusion for those seeking information on a very specific use of life insurance when applying for a loan (usually a small business loan).  Lots of banks allow a borrower to pledged the death benefit of a life insurance policy as security for a loan and this is usually permissible across all three types of life insurance.  So while you cannot borrow from a term life insurance policy because it does not build cash value, you can (if the bank allows it) use the death benefit of a term life policy to secure a loan.

So assuming you own either whole life or universal life insurance and you have cash value accumulated within the policy and you'd like to borrow money from the policy what else do you need to know?

Some Have a Minimum In Force Waiting Period

Some life insurance policies do require that the policy is in force for a minimum amount of time before a policy loan is available regardless of how much cash value the policy has.  This minimum amount of time is generally no longer than one year.  So for some life insurance contracts, you cannot borrow from the policy until after the first policy year is complete.  You can easily ascertain if you own a policy with such a provision by contacting the customer service department and asking if such a restriction exists on your policy.

You are Borrowing Against your Policy NOT From your Policy

This wording might seem picky but the mechanics of this can be substantially in your favor.  When you initiate a policy loan from a life insurance policy you are not removing any of the money in the policy.  Instead, you are requesting a loan from the life insurance company and you are automatically pledging the cash value in your life insurance policy as collateral for the loan.

This means that the cash inside your policy will continue to grow at least at the guaranteed rate of accumulation and often at some other non-guaranteed rate.  The exact functionality differs between whole life insurance universal life insurance so you might want to take some time to understand such elements of your policy before requesting the loan.

So much like your home will continue to grow in value if you take out a home equity loan against it, life insurance cash values will continue to accumulate and grow in value despite your taking a policy loan out against them.  But unlike real-estate, most life insurance contracts are contractually guaranteed to increase in value each year (variable life insurance products excluded from this statement).

The Life Insurance Policy Loan Process

Approaching a new process for anything can be a tad intimidating, so allow me to elaborate a bit on the life insurance policy loan process for those with little to no experience with this.  Hopefully, it will give you some degree of comfort in navigating such a request for the first time.

Request the Loan

It's probably no surprise that the loan process begins with a request for a loan.  The policyholder can make this request directly to the insurance company or he/she can make the request to his/her agent/broker.  Once the insurance company officially received the request, it will begin working on processing the loan.  Loan take on average a week to process (i.e. receive the request and a check is produced and mailed to the policyholder).

Payment Made Via Check, EFT, or Wire

Depending on the options available by the life insurance or the wishes of the policyholder payments are usually available as either a check, EFT, or wire transfer.

Checks sent by regular mail and/or EFT generally do not include any additional charges.  Overnight checks usually require the policyholder to pay the overnight shipping cost.  Wire transfers can incur bank wiring fees (there usually isn't an additional fee levied by the insurer for wires).

Once the policyholder received the cash in whatever method he/she chooses he/she is then free to do whatever he/she intended to do with the money.

Interest Accumulates

Interest on a policy loan begins to accumulate the day the loan originates.  Life insurers fall into one of two possible categories for when and how they charge interest on a life insurance policy loan.  The two categories are 1.) in advance or 2.) in arrears.

Charging interest in advance means the life insurer will charge all of the interest assumed due for the year when the loan originates and will do so again at the beginning of the next policy year.  Under this arrangement, the life insurer assumes that the loan balance will remain outstanding for the entire remainder of the policy year.  Let's use an example to further explain this concept.

[thrive_text_block color=”blue” headline=”Charging Interest in Advance”]Kyle requests a life insurance policy loan where the life insurer charges interest in advance.  Kyle is requesting a $10,000 loan and the loan interest rate on his policy is 8%.  The life insurer will charge $800 in interest and add it to Kyle's loan balance as soon the insurer processes the loan.  Assuming Kyle makes no payments to the loan, at the next policy anniversary the life insurer will charge $864 in interest ($10,800 balance x 0.08 interest rate = $864 in new interest charged) and add it to Kyle's loan balance.[/thrive_text_block]

When a life insurance company charges interest in advance, they will charge interest on the loan assuming that the full loan amount will remain outstanding for the entire policy year.  For many situations, this assumption will not hold true and payments made throughout the policy year will reduce the principal balance of the loan and therefore reduce the interest charged at the beginning of the next policy year.  However, charging interest in this fashion does result in the insurer being able to charge more interest on the balance of the loan before the policyholder has a chance to make any loan repayment.

Additionally, charging interest in advance causes a mismatch of timing for policy value accumulations versus loan balance accumulation since guaranteed interest generally accumulates throughout the year and non-guaranteed elements are often earned at the end of the policy year.  This means the loan balance of a policy where interest charges take place in advance can grow faster than cash value due to the timing of the loan interest charge versus the timing of the cash value interest accumulation.  The loan interest compounds sooner in the year than both the guaranteed and non-guaranteed interest on the cash value.

Some insurers attempt to compensate policyholders for this by applying an interest adjustment factor to the loan that ultimately reduces the effective loan interest rate.  Take the example above and assume that the insurance company uses such an interest adjustment factor making the effective loan interest rate 7.5%.  Now instead of having $800 of loan interest accumulate immediately, Kyle has $750 of loan interest accumulate immediately.  At the beginning of the second policy year, Kyle would have $806.25 of loan interest accumulate.  This saves Kyle $107.75 in loan interest compared to a policy with no interest adjustment factor.

Interest charged in arrears means the insurance company does not add the interest due to the loan balance until the end of the policy year.  For these policies, interest begins accumulating at the outset of the loan and the accumulation takes place daily based on the loan balance.  The interest accumulates proportionately per the day.  An example will help explain.

[thrive_text_block color=”blue” headline=”Charging Interest in Arrears”]Donna owns a life insurance policy from which she wishes to take a $10,000 policy loan.  The life insurer charges interest in arrears and the annual loan interest rate is 8%.  On the first day of the loan, ~$2.19 of interest will accumulate.  This same ~$2.19 will accumulate each day of the year assuming Donna makes no payments towards the loan.

At the end of the policy year, the life insurer will send Donna a notice informing her that $800 of loan interest accumulated on her loan and she can either send an $800 payment to the insurer or else the insurer will add the loan interest to the current loan balance.

Assuming Donna decides to allow the loan interest to accumulate (i.e. adds the interest to the loan balance) the loan will begin accumulating ~$2.37 per day beginning on the first day of the second policy year.[/thrive_text_block]

Unlike the policy where the insurer charges loan interest in advance if Donna makes payments to the loan throughout the policy year, this will affect the loan interest charged in the first year.  For example, if Donna made a $2,000 payment to the loan six months after originating the loan, her interest balance due at the end of the first policy year would be $720 instead of $800.

If we go back to Kyle, payments made in the first policy year do not affect the loan interest charged because that takes place immediately at loan origination.  Kyle would realize a smaller loan charge at the beginning of the second policy year.

Adjustments Might Occur to Policy Value Accumulations

Depending on the type of life insurance policy you own and the specific practices at the insurance company, you might experience adjustments to the accumulation rate of value values pledged as collateral for the loan.  This adjustment differs considerably across life insurers and product types, but we can broadly categorize these adjustments when talking specifically about whole life insurance or universal life insurance.

When it comes to whole life insurance, you will always receive the guarantee interest accumulation on all cash value regardless of outstanding loan activity.  You might experience a different dividend on portions of the policy that act as collateral for an outstanding loan.  The industry term for how a life insurer treats the dividend with outstanding loan activity is dividend recognition.  There are two possible options concerning dividend recognition.

For life insurers that practice non-direct recognition, you receive the same dividend regardless of outstanding loan activity.  The life insurer makes no change to the dividend you earn on your policy because you have an outstanding policy loan.

For life insurers that practice direct recognition, the life insurer will adjust the dividend paid towards portions of your policy that act as collateral for your outstanding loan.  This adjustment could be either a positive or negative adjustment, depending on the current dividend interest rate and the current loan interest rate.  For most life insurer, this adjustment is a negative adjustment to the dividend payable on portions of the policy that act as collateral for the loan.

Notice that with direct recognition the adjustment only affects portions of the policy that act as collateral for the loan.  Portions of your whole life policy that do not act as collateral for the loan do not experience an adjustment and receive the dividend payable to policies with no outstanding loan activity.

Important Details About Oustanding Life Insurance Policy Loans

While technically classified as a loan, there are a lot of differences between loans issued against a life insurance policy and traditional loans–i.e. those issued by banks and similar lending institutions.  It's important to understand these differences as they can be both strategically beneficial and helpful to understand and plan out which option you should take.

Does not Come with a Repayment Booklet

The life insurer will never tell you that a periodic payment is due on your policy loan.  This is because there is no specific due date or repayment schedule for  life insurance policy loans.  Yes technically interest is due at some point, but you can opt to add the loan interest to the loan balance and effectively skip that payment (lots of people do it every day).

The life insurer will also not give you any sort of recommended repayment schedule.  Repaying a life insurance loan (if that's the plan) is entirely up to the policyholder's discretion.  This can be both liberating and intimidating.  If you are repaying the loan, is the amount of your repayment enough?  What if you forget to make a payment?  What happens if you find yourself in a situation where you cannot make the payment?

The good news is you're not in any trouble with the life insurer if you don't make repayments.  You're under no obligation to maintain the repayments to started making and can switch when and how much you pay at any time.

Loan Interest is NOT Amortized (Mixed in with your Repayments)

We established already that interest on a life insurance loan accumulates daily (if due in arrears) or the insurer charges all of the assumed interest accumulated for the year at the beginning of each policy year.  In either case, repayments made throughout the year ONLY apply to principle.

This means each payment you make to the loan at whatever interval you choose, will go 100% to reducing the loan balance.

This works differently than traditional lending from a bank.  Those loans amortized the interest.  This means the lending institution mixes the interest due in with each payment and can make a substantial portion of your first several payments largely interest–leaving little to pay down interest.

Because of the unique way that life insurers charge interest to policy loans, you'll end up paying fewer interest expenses on a life insurance loan at the same annual interest rate than you would on a traditional loan issued by a bank.

Life Insurance Policy Loans are not “Public” Loans

Life insurance companies are not banks and they do not traditionally engage in the same information collecting process that banks do for the sake of evaluating everyone for their creditworthiness.  Life insurers do not report loan activity to credit bureaus.  This means that if you have an outstanding policy loan, a lender cannot see it by virtue of pulling your credit report and the payments to make to that loan (if any) do not affect your debt-to-income ratio.

Further failing to make repayments to a life insurance loan does not affect your credit score.  Also, taking out a life insurance loan and repaying it will not affect your credit score.

You are Free to Do Whatever you want with the Money

Loans issued by life insurers do not come with strings attached.  Insurers cannot issue life insurance policy loans stipulating that the money only goes towards some specific purpose.  Those who own life insurance where loans are a feature can borrow against life insurance policies at any time for any reason without consequence or penalty due to age.

Additionally, life insurers do not underwrite loans.  This means you do not have to prove any sort of creditworthiness to the life insurer to take out a loan against your life insurance policy.  Your history of repaying loans or lapsing policies due to excessive loan activity on an old life insurance policy has no effect on your ability to borrow against a new or different life insurance policy.