How Do Life Insurance Loans Work?

If you have permanent life insurance, you could take out a loan, using your policy as collateral.

Borrowing money from your life insurance policy is one way to get quick access to liquid capital in a pinch.

Many people also use it to save themselves from more predatory loans for surprise expenses.

However, a life insurance loan (also called a policy loan) operates differently than standard bank loans, so it’s important to understand the basics.

What Is a Life Insurance Loan?

A life insurance loan lets you borrow money from your insurance company, secured by your policy.

You can only borrow up to the amount of cash value your policy has built up. Your death benefit functions as the collateral. 

Not every type of life insurance policy builds cash value. There are also some tax rules to consider. 

The Difference Between Loans, Withdrawals, and Surrender

You’ve likely heard of policy withdrawals and surrender. They differ from life insurance loans in a few notable ways.

Loans: With a loan, you’re borrowing against the cash value of your policy. Withdrawals: A withdrawal reduces your policy’s death benefit and cash value. When you make a withdrawal, the cash is subject to taxes if you take out more than you paid in premiums. It also permanently reduces the amount available to you in the future. Surrender: A full surrender involves canceling your policy in exchange for the surrender or cash value of your policy while a partial surrender is similar to withdrawal, removing some cash, but still keeping your policy in force.

Most policies have a surrender charge for the first 10 to 15 years of the contract. The surrender charge is subtracted from the cash value that is paid to you. 

How to Take Out a Life Insurance Loan

Applying for a life insurance loan is easy, but there are a few things to keep in mind.

The Application Process

To take out a life insurance loan, you simply fill out a form to get the amount of cash value you want. 

The best part of the application process is that it’s only a simple form with zero underwriting involved.

When you apply for a loan, there’s:

no credit checkno interviewno explanation needed for why you want to access the money

In-force Illustrations

Before you apply for a loan, you should ask your agent for an in-force illustration, which shows you potential outcomes for your policy considering the loan. 

The more information you have upfront, the better. It prevents you from being surprised by a policy lapse if the interest on the loan outpaces the cash value growth.

An in-force illustration shows you what will happen to your active policy when you take out the loan, helping you to decide whether it fits within your financial situation.

Repayment Options

Unlike other types of loans, a life insurance loan allows you to repay on your own schedule – or never.

The life insurance company holds the death benefit as collateral, so if you choose to use the loan as, say, supplemental retirement income, you don’t have to pay it back.

The loan amount plus interest will be deducted from the death benefit paid to your beneficiary. 

You can structure the repayment plan however you like. Choosing to repay is smart if you aren’t using the loan for retirement income.

The critical thing to keep in mind is that the loan’s interest compounds each year and most companies structure the repayment to pay down the interest before the principal. 

The most common ways of repayment are: 

Periodic payments plus annual interestPaying the annual interest onlyDeducting the interest owed from the cash value remaining

Interest Rates on Life Insurance Loans

5 to 8%

Interest rates are fixed or variable depending on the company. Currently, they fall in the 5 to 8% range. 

If it’s a fixed interest rate, you’ll know up front.

If you plan to take advantage of life insurance loans someday, talk with your agents about the companies with the best track records. 

Some companies even offer variable loan options where you can pay the current interest rate or lock in the rate of interest when you take out the loan. 

Compounding Interest on Loans

The majority of life insurance loans have annual compound interest. Each year the amount owed will increase by the stated interest rate.

Because it compounds each year, the total amount (not the principal amount) will increase by the interest rate. 

For example, if you have a $10,000 loan at 5% interest, you will owe $10,500 at the end of the year.

The next year, that 5% interest will apply to the total amount, not just the original $10,000 you borrowed.

At the end of next year, the compounded amount would grow to $11,025 instead of $11,000. 

This is why you can only pay down the interest if you choose to use your cash value for supplemental retirement. 

How Cash Value Accumulates

The way the cash value accumulates within the policy depends on the type of coverage you have.

Part of your premiums goes toward building the cash value. This accumulates over time, plus additional growth. 

After 10 to 15 years, you have a pool of money to draw from. 

Whole Life Cash Value Growth

Whole life policies grow their cash value based on dividends.

This is typically a number generated by the insurance company reflecting how profitable they were for the past year. 

2 to 4%

Many companies have a guaranteed level of growth, roughly 2%, but you aren’t likely to see more than 4% growth on your cash value. 

Universal Life Cash Value Growth

Universal life accumulates interest on the cash value based on either the current market or minimum interest rate.

It usually defaults to whichever amount is greater, but again, everything depends on the company. 

Variable Universal Cash Value Growth

Variable universal life invests your cash value directly into a market, like the S&P 500 index.

This allows for unlimited growth in good years, but also unlimited loss in bad years. 

It’s one of the most complex types of life insurance policies available. 

Indexed Universal Cash Value Growth

Indexed universal life (IUL) is unique from other policy types, functioning more as a wealth-building tool than life insurance.

People choose IUL because it has the potential for double-digit cash value growth with a 0% growth floor. 

The insurer ties the cash value growth to an index, but it’s not directly invested in the market.

If the S&P 500 grows 9% that year, your cash value increases by 9%. IULs also have a floor, so if the market crashes, your cash value remains the same. 

To counterbalance this, IULs also have a ceiling – usually between 12% and 14%.

If the market grows 15% that year, your cash value would only increase by the cap amount. Some indices are uncapped, with the indices available varying by company.

Using a Life Insurance Loan for Supplemental Retirement Funds

Loans aren’t taxable.

How does tax-free retirement income sound? 

It’s a supplemental retirement income strategy well-to-do families have been using for decades.

A life insurance loan is not a replacement for more common retirement savings methods. Instead, it should be a supplement. 

People using this strategy typically need to be earning at least $60,000 annually.

They’ll also need an experienced insurance agent to set up the policy to focus on building cash value rather than maximizing the death benefit. 

Most agents specializing in this strategy will recommend indexed universal life policies.

They are highly customizable, lower-risk, and have the option to leverage bank loans into quadrupling the cash value growth. 

Advantages of Life Insurance Loans

Any type of financial vehicle has a potential for great gains along with correlated risks. Borrowing money from your life insurance isn’t any different.

Here are the biggest advantages of taking out a life insurance loan.

Competitive Interest Rates

Life insurance loans often beat market rates.

We’ve all seen ads for low-interest home and car loans, but average interest rates on personal loans and credit cards start in the double digits. 

Flexible Repayment

You can repay a life insurance loan on your schedule.

When you get the in-force illustration, it’ll show you what happens if you don’t repay the loan and varying repayment schedules. 

No Credit Check 

One of the best parts of a life insurance loan is that it won’t show up on your credit report. 

The insurer doesn’t care why you want the money. You can use it for anything, like paying down higher-interest debt, funding a vacation, or putting extra cash in retirement. 

Opportunity Cost

If you have $10,000 invested in the stock market and sell $2,000 of it, you’re down to $8,000.

If the market grows by 10%, you have $8,800 instead of the $11,000 you could have had if you hadn’t sold the stocks. 

The difference is the opportunity cost. 

Life insurance loans don’t have opportunity cost because you aren’t actually borrowing from your cash value. It keeps growing even as you borrow. 

Cash Value Credit Protection

In roughly half of the states, creditors cannot go after your life insurance policy.

By extension, they cannot seize the cash value in your life insurance policy. 

Sometimes life happens. In this case, your life insurance’s cash value can be an invaluable safety net to protect your family from vultures. 

Risks of Life Insurance Loans

Life insurance loans do have their risks.

Many can be avoided by careful calculation and research, while others will need to be weighed in relation to the benefits. 

Accidental Policy Lapse

If your loan and accrued interest exceeds your policy’s cash value, the policy can lapse. 

If the policy lapses, the loan becomes taxable income. The IRS wants its share of any income, and the moment your loan is no longer a loan, you’ll owe the IRS money. 

Banks May Have Lower Interest Rates

Depending on what you’re using the money for, you might get better interest rates by applying for a specific loan. 

10 to 15 years

You also may not be able to borrow from your policy for the first 10 to 15 years.

While most policies technically allow you to start borrowing against the cash value after a few years, slower growth policies may have little built up until you get a dozen or so years in. 

Potential Dividend Reduction

Choosing not to repay the loan can result in the company automatically assigning your dividends to pay off your loan or interest instead of growing your cash value.

This presents problems if you rely on those dividends to increase your cash value and keep your policy in force. 

Policy Lapse Risk

When there is no available cash value for the insurance company to hold as collateral against your loan, the policy will lapse. 

You can run out the cash value by letting the interest grow too much.

For example, say you have a whole life policy that grows 4% every year and your interest is locked at 7%.

Your loan plus interest will eventually catch up to the total cash value if you don’t pay back the loan. 

When the policy lapses, any remaining loan becomes taxable as income.

Tax Traps

Loans from your life insurance policy do not incur any taxes. Technically, it’s a loan, so the IRS can’t tax it.

This is great news if you’re using it to supplement your retirement. 

However, the moment your policy lapses (if something goes wrong with the policy mechanics), any outstanding loans from your policy become taxable income. 

Frequently Asked Questions

Why won’t a bank give you a life insurance loan?

While some banks require life insurance policies to be in place before they issue certain types of loans, it’s not an asset they can seize for money if you decide not to repay.

The named beneficiary only gets the benefits if you pass away. Plus, what would happen if you choose to stop paying the policy premiums?
Instead, the life insurance loan comes from your life insurance company with the policy as collateral. 

Why can’t you get a loan as soon as you take out the policy?

While technically you can take out a loan after you’ve held the policy a few years, you likely won’t have enough cash value to borrow against it until decades later. 

It doesn’t make financial sense for the insurance company to lend you money when you haven’t paid much in premiums yet. 

Why can’t you get a loan with a term policy?

Term policies don’t hold any cash value. That’s why they’re more affordable than permanent policies.

Even then, some permanent policies don’t have any cash value, either. 

How do loans affect living benefits?

Today, most permanent life insurance policies include some level of living benefits.

These allow you to access your death benefit early if you are diagnosed with severe medical conditions or need a nursing home. 

If your policy is structured to reduce the benefit as you borrow from it, you’ll have less cash available to take advantage of these extra perks. 

How do interest rates on life insurance loans compare to other loan types?

Compared to the rates you might pay on a car or home loan with excellent credit, a life insurance loan may not be a great deal.
However, compared to credit card interest or personal bank loans, a life insurance loan may be the smarter option. 

How do over-loan protection riders work?

A few companies offer over-loan protection riders on their cash value-focused policies, at an extra cost.
An over-loan protection rider prevents a part of your death benefit from being eaten while paying for the interest on your loan. 
The downside is how most companies write this rider.
It doesn’t go into effect until you’re 75-years-old and have accumulated at least $100,000 in the policy.