Borrowing From a Life Insurance Policy - What You Need To Know

A Good or Bad Idea?

Woman reviewing investments in life insurance with daughter in background
When It Makes Sense to Borrow from a Life Insurance Policy. tetra Images / Getty Images

Although traditional life insurance was developed to provide a death benefit to a beneficiary in the event of the insured person's death, several products evolved in the latter part of the 20th century that incorporated savings or investment. Borrowing from a life insurance policy can be considered if you have a permanent life insurance policy with values. Two examples of life insurance policies that provide cash values are whole life insurance and universal life insurance.

Check your life insurance policy to see if it includes a loan provision.

Can You Borrow Money From Term Life Insurance Policies?

Cheap life insurance like term life insurance does not allow you to borrow money from the policy. The reason term life insurance is considered affordable or cheap, is because it is a pure life insurance policy, it has no value other than the actual death benefit to be payable upon the death of the insured, if the insured dies during the fixed term. 

The Basics of Borrowing From Your Life Insurance Policy 

If you are thinking about borrowing from your life insurance policy, you probably were sold a policy that offered cash values and used this as part of your strategy in deciding what kind of life insurance is best for you. The first thing you need to do if you are considering borrowing money or withdrawing funds from your life insurance is deciding if it makes sense in your circumstance.

Before you borrow, ask your agent or representative to run an "in-force illustration." An in-force illustration will show you how your loan will impact your policy. Also, explore other options and weigh the pros and cons of borrowing from your policy.

How Does Borrowing From a Life Insurance Policy Work?

When you borrow based on the cash value of your life insurance policy, you are borrowing money from the life insurance company.

A loan from your insurance company is a lot easier to get than a bank loan because they are using the cash value of your policy as collateral. If you do not pay back the loan, they will take it from the cash value of your policy or your death benefit. One of the main problems with this is that if the loan is not paid back, and you don't pay the interest, then the interest will compound and be added to your loan balance, and may end up exceeding the cash value. Borrowing from your life insurance policy requires cautious planning and monitoring of your loan balance and cash values or you might risk losing your policy. This is where an in-force illustration will come in handy. 

When Can You Borrow From Your Life Insurance Policy?

You can typically borrow or take cash from your life insurance policy after you have built the cash value. You will have to contact your financial planner or advisor, or your life insurance representative to find out what your cash value is and to discuss what the impact will be on your policy as well as if there will be tax implications.

There are several factors that you need to consider before you cancel or cash out a life insurance policy, borrow against it or take cash values.

Do You Have to Pay Back the Loan When Borrowing From Your Life Insurance Policy?

Unlike bank loans or mortgages, you do not have to pay back the loan you take when borrowing from a permanent life insurance policy. However, when you borrow the money based on your cash value, the amount you borrow may reduce the death benefit from the life insurance portion of your policy. If you do not pay the loan back and the interest combined with the amount borrowed starts to exceed the cash value, you could put your life insurance policy at risk. This can happen more quickly than you think.

5 Things to Check Before Borrowing From a Life Insurance Policy

Before you borrow from a life insurance policy, you need to have a serious discussion with your financial planner or insurance advisor to understand the long term and short term consequences and risks.

There are many hidden costs that you may not initially realize, and you want to make sure this is the best option for you. 

  • Discuss how the loan and interest will impact your life insurance policy to make sure that the death benefit portion of your policy is not threatened.
  • Find out if you will have to pay an "opportunity cost"
  • Make sure you can afford to pay the interest and other fees or figure out the strategy based on your specific policy that will make sense for you. Not all policies are the same and everyone's circumstance is different.
  • If you can not pay back the interest on your loan, think twice. The in-force illustration will help you understand this aspect.
  • If you are relying on the dividends of your policy to pay the interest on the loan, have a real look at the details with your representative or financial advisor. This can be costly if not structured properly.

All of these issues should come up when you look at the in-force illustration of the impact of your loan with your agent or advisor. 

Reasons to Borrow From a Life Insurance Policy vs. the Bank

Some people bought life insurance with values specifically to build assets so that later on in life they can borrow from their life insurance policy or use the investments when they need to.

  • Some people borrow from their life insurance policy to avoid the hassle of a loan from the bank. If you have the intention of repaying the loan in a reasonable amount of time, and keeping up with the interest payments so they do not accumulate, then this could be a hassle free option.
  • Borrowing from your life insurance policy allows a lot more flexibility in repayment. For example, when you borrow from a bank, you have monthly payments to make over a fixed term, whereas if you borrow from your life insurance policy, you can pay back as little or as much as you want at any time interval. Again, you have to be careful how this impacts the value of your loan, vs. your cash value as interest accumulates, but if you only need a loan for a brief time, this can really help you borrow money and pay it back on your terms.
  • If the amount you are borrowing is significantly less than your cash value and you have plans and the means to pay back the interest and value in a reasonable amount of time (your life insurance agent can help you figure this out), then borrowing from your policy will be a good option for you.

You can borrow from a cash value permanent policy, but before you do make sure you are prepared to manage the transaction properly by having a thorough discussion with your planner.

Beware of the Real Implication of Borrowing From Your Life Insurance Policy

We've given you a basic list of things to look out for if you're considering borrowing from your policy, this information can be used as a starting point to discuss the option with your licensed advisor or representative and make an informed decision. There are smart ways to manage borrowing from your life insurance policy that can provide good benefits, but there are also risks when it is not done with careful planning.

An example of how borrowing from your life insurance policy could be a problem, especially if you are borrowing money because you are having hard financial times, is that your cash value in your life policy is protected from creditors, but a loan from your life insurance policy is considered cash, and so this is no longer protected from creditors.

The last thing you need is to take out a loan without having the big picture. What is most important for you to keep in mind is that this is not the same as pulling money out of a savings account, it's a complex transaction and you need to make sure you really understand it.

Examples of Borrowing Money From a Life Insurance Policy

Jane had been paying into her whole life insurance policy since she was 22. On her 40th birthday, she decided that she wanted to buy herself the sailboat she had always dreamed about as a gift to herself and spend some time on the water with the kids that summer before they became teenagers and got too busy to take the time to spend with family.

She was still paying off her home, so she didn't want to take out an additional loan, so she decided to use some of her savings, and borrow the remaining $20,000 she needed from the cash value of her life insurance policy.

When she called to get the loan and discussed the consequences with her financial advisor, she found out that she could borrow the money, but that the amount might reduce the amount of her death benefit. This would mean that if something happened to her and she died, her family would only get the death benefit, less the amount of the loan if she didn't pay it back. That didn't bother her so much, but then her financial advisor went on to explain that even though she didn't have to pay back the loan, she could end up paying interest, and compound interest. When they worked out the details, Jane decided the loan for the sailboat probably wasn't the best use of her accumulated cash value, and she decided to rent a boat instead, and not risk paying all the fees and compound interest or risk her policy long term.

Example of Borrowing From a Life Insurance Policy to Start a Business

Jane decides she wants to take money from her life insurance policy to start her own business. She has never run a business before, so she is worried about borrowing from the bank. She also doesn't want to have another loan on her credit report. Because Jane has already done some market research and has had some demand for her services already, she thinks she can manage to pay back her life insurance loan within two years. Borrowing the money as an investment into herself and the future business makes sense, so she takes out the loan.