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Borrowing Against Life Insurance - What You Need to Know

There is a way to get access to lending in a few days, usually with low-interest rates and without having to go through credit checks. It is what makes borrowing against life insurance policies attractive to many people. It may be a great option if you need cash fast and without as much paperwork as the banks may put you through, especially if you have a bad credit history. However, it should not be mistaken for free money. It comes with its own risks and disadvantages that should be considered first. Here is a look at what borrowing against your life insurance policy looks like.
 

What types of life insurance policies can you borrow against?

Not all life insurance policies allow you to borrow against them. Only those with cash value components are eligible for this kind of lending because the cash value acts as collateral. Two types of policies you can borrow against are whole life insurance policies and universal life insurance policies.
 

How does borrowing against life insurance policies work?

As mentioned earlier, the loan is taken against the cash value of your policy. This does not mean you are cashing out the policy itself. Your insurer lends you the sum of money you requested while they hold the cash value of your life insurance policy as collateral for the loan.

The loan can only be given to you as the policy owner; beneficiaries of your policy are not entitled to the same. Naturally part of the process of getting this loan involves verifying that you are the owner of the policy. Your insurer will help you figure out how much you can borrow and at what interest rate before giving you a forms to fill out. After selecting how you would like to receive the money, the lending process should be done in a matter of days.
 

Are there benefits to borrowing against your life insurance policy?

The process of applying for normal bank loans can be tedious and quite demanding. Even when everything checks out, there is always the possibility that the credit officer at your bank will turn you down for subjective reasons. Borrowing against your life insurance policy is more certain, you usually will not need the usual credit checks that banks use. They do not even need to know what the money is meant for. Why? The cash value of your policy acts as collateral. Even if you do not pay back your loan, your insurance company is assured they will get their money back. This can be a great lifeline when you need money urgently.

  • This kind of loan does not affect your credit rating even if you do not pay it back.
  • Compared to bank loans, loans against your policy have friendlier interest rates because of their low-risk nature. Your insurer is sure they will get their money back either way.
  • Unlike normal bank loans, borrowing against your policy generally does not have any fixed timeline for repayment.
  • Withdrawals from whole life policies and universal life policies are exempt from taxes. Loans against your policy fall under this category of "withdrawals." Therefore, borrowing against your life insurance policy is exempt from taxes.
     

What are some of the drawbacks of borrowing against your life insurance policy?

The main objective of getting a life policy is to leave a safety net for your loved ones in the event that you die. If you borrow against your policy and become deceased before repaying your loan, you are eating into the benefit they would receive. 

Due to the lax nature of the loan repayment structure of this kind of loan, it is very easy not to pay your interest owed every year. While interest rates might be low, failing to pay can quickly compound the amount of money you owe. When that figure exceeds the cash value of your life insurance policy, your policy could lapse and get canceled. Insurers are generally more forgiving than banks with loans and tend to give their clients opportunities to make things right, but the risk of losing your policy should not be ignored.

There's a caveat to the "tax-free" rule on borrowing against your policy. The rule only applies when your policy is intact. So, if your policy lapses before you complete repaying your loan, your loan becomes a taxable event. That can be expensive and ugly depending on how much you have borrowed.
 

How much can you borrow against your life insurance policy?

In theory, your insurer will allow a maximum of the cash value of your life insurance policy. The reality is quite different. Once you factor in interest rates and other fees for processing the loan, they usually let you borrow up to 90% of the cash value of your life insurance policy. But, even that is not a certainty. Each insurance company has their own unique policies on how to handle this kind of loan.
 

When can you borrow against your policy?

Since you cannot borrow more than the cash value of your policy, the first thing to consider would be whether the cash value of your policy at least matches the amount you would like to borrow. Remember the cash value takes time to build up, usually years. Some insurers have a minimum waiting period before you are allowed to borrow against your policy. Assuming there is no stipulated waiting period, you should be able to borrow against the policy as long as it has a large enough cash value to match the amount you would like to borrow.
 

What about paying back the loan? 

Since you are effectively borrowing from yourself, there isn't any specific time by which you are expected to clear your loan. With that said, you are still required to pay your insurance premiums. Not paying your premiums and the compound interest accrued on your loan can eat into your policy benefits faster than most people realize. Left unchecked, this may exceed the cash value of your policy, which may then cause your life insurance policy to lapse. Let's not forget that your lapsed policy may trigger a hefty tax penalty on the cash value of your policy. It is safer to pay as much as you can as soon as you can to make sure your loved ones are still entitled to their benefits in the event of your death.   
 

What are the tax implications of borrowing against your life insurance policy?

There are no tax implications of borrowing against your life insurance policy. However, if your policy lapses before you complete your loan repayments, a tax penalty is incurred on the cash value of your policy.  
 

What are some additional lending options you should consider?

Withdraw from your Roth IRA

Unlike most retirement accounts, you cannot borrow against your Roth IRA and IRA accounts. Instead, what you can do is withdraw money from your Roth IRA. The sum withdrawn is tax-free if you reinvest it in 60 days or less. If you do not, you incur a 10% penalty on the sum you have not reinvested. It is a great option if you need cash you are sure you will return in 60 days or less. Think of it as a quick interest-free loan.
 

Use a 401(k) loan

Note that not all 401(k) accounts allow this kind of borrowing. Also, this is not a loan in the traditional sense of a bank loan. It is more like withdrawing money from your retirement account tax-free with the promise to reinvest the amount borrowed plus a predetermined interest. So, even if you pay interest, it goes back into to 401(k) and not to a bank or other lender. You are effectively borrowing from yourself. The only problem with these is that losing your job or changing jobs before you repay the amount triggers a 90-day period in which you are expected to pay the remainder in full. If you do not, the unpaid amount becomes taxable, and you incur an extra 10% penalty.
 

Home Equity loans

Homeowners have access to secured loans in which they use their homes as collateral. They are simple and straightforward provided you own the property you are using as collateral. The interest rates are cheaper than other consumer loans. However, defaulting on these could lead to you losing your home or property.