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Borrowing against your life insurance policy

Fact-checked with HomeInsurance.com

When you need access to cash, there are many options available – all with pros and cons depending on your needs and financial situation. By now, you’re probably familiar with some of the most common options: credit cards, personal loans and mortgage refinancing are just a few. But an often-overlooked option is to borrow against life insurance by using the policy’s cash value to secure relatively low-risk, low-cost financing.

Three out of five Americans are covered by some form of life insurance, and for some of them, life insurance loans may provide the best solution in times of financial need. But not all types of life insurance policy plans are eligible to secure a loan.

Can you borrow from life insurance? In this guide, we’ll explain the qualifications you’ll have to meet before you can even consider this option.

What is borrowing against your life insurance policy?

Taking out a life insurance loan may sound complicated, but it’s actually a fairly straightforward process. Borrowing from life insurance essentially involves getting a secured loan using your life insurance policy’s cash value as collateral. Under the right circumstances, life insurance policyholders can use the cash value they’ve already accumulated to obtain financing with better terms than traditional loans. The maximum loan amount depends on your policy’s current cash value; the more you’ve paid in via premiums, the more you’ll have to borrow from.

Who should borrow from life insurance?

The most important thing to understand about borrowing from life insurance is that only certain types of policies even carry the option of being used to secure financing. Keep in mind that there are generally two types of life insurance policies: term and whole life insurance. Term life insurance is only valid for a certain number of years and has no value if the policyholder outlives the effective period. If you have a term life insurance policy, it won’t do you any good in getting a loan.

Whole life insurance, on the other hand, accumulates a cash value over time that never goes away. It is this type of policy that can be a candidate for financing – although it isn’t a given. Unless you’ve been paying your life insurance premiums for several years, you may not yet be eligible to borrow from your policy. This is because it takes time for the policy to build up a cash value. If you just took out the policy last year, you probably don’t yet have enough of a cash value to borrow against.

Should you borrow against your life insurance policy?

ProsCons
Easier to get than bank loansCompound interest
Doesn’t impact credit scoreReduced death benefit
Lower interest ratesTax implications
Flexible repayment terms 

Pros of borrowing against your policy

Easier access to funds

If you’re worried about a low credit score hindering your ability to get a loan, you’ll be relieved to hear that life insurance loans don’t involve a credit check. There’s no risk of being denied the loan due to creditworthiness.

Doesn’t impact credit score

Since borrowing from life insurance doesn’t require a hard inquiry on your credit, getting one also won’t affect your credit score. If you’ve recently applied for a loan and been denied, this can be a huge advantage. Multiple hard inquiries at once are seen as a red flag to future lenders. In bypassing this step, you’ll help preserve the score you do have and make it easier to secure financing down the line.

Lower interest rates

The average rate on a two-year personal loan is about 10.3 percent, but in some instances, a life insurance loan can be just half this. Borrowing from your life insurance policy plan usually incurs an interest rate of only five to eight percent. On a $10,000 loan, you could save up to $540 in interest payments over the course of two years.

Flexible repayment terms

If you’re in a bind and need cash, you may not be in a position to know what type of repayment plan you can afford just yet. Unfortunately, most types of traditional financing require you to commit to a schedule up front with little wiggle room and severe penalties if you fail to make payments on time. Life insurance loans are much more flexible, allowing you to pay back the sum on your own terms as your financial situation evolves.

Cons of borrowing against your policy

Compound interest

With relatively little structure to life insurance loan repayments, some borrowers may choose not to make interest payments up front and instead have them added to the overall loan balance. While this may seem like a good idea at first, you should keep a close eye on the balance. Interest will compound over time, driving up the total loan amount faster than it can accumulate value. Letting that balance grow to the point that it overtakes your policy’s cash value could spell bad news, triggering both a loss of coverage and an outstanding tax bill.

Reduced death benefit

Your life insurance policy plan’s cash value will never change. However, the policy’s death benefit – or the amount that the beneficiaries will receive in the event of your death – absolutely can. Once you borrow from life insurance, you’ll face a reduced death benefit until the loan is repaid. If anything happens before you can pay the loan back, your loved ones won’t receive the full amount they’d otherwise be entitled to.

Tax implications

Life insurance proceeds are generally exempt from taxation if paid out upon the policyholder’s death. But if your policy lapses for any reason, including if compound interest raises the loan amount to exceed its cash value, the IRS will come knocking to collect taxes on the benefits you received. You’ll even be taxed on the interest that accumulated.

Times to borrow against your life insurance policy

Depending on your financial situation, taking a loan against your life insurance policy is likely just one of many different financing options. So how do you know whether borrowing from life insurance is the right option? While there’s no right or wrong answer, it may be the best idea if other alternatives are costly or too much of a risk.

You have poor credit

If your credit score has prevented you from being approved for a personal loan, borrowing from life insurance may be the only feasible option. Even if you can find financing with a low credit score, you’ll likely be given a much higher interest rate than those with good credit. In contrast, if you take out a life insurance loan, you’ll be given the same interest rate as anyone else regardless of your credit.

You aren’t sure when you can repay the loan

If financial uncertainty is what drove you to pursue a loan in the first place, committing to repayment terms you can’t afford could just create a bigger snowball to an even worse financial situation. Life insurance loans aren’t entirely risk-free, but they certainly pose a much lower threat to your long-term finances.

How to borrow against your life insurance policy

Once you’ve established that you’re a candidate for a life insurance loan, securing financing isn’t a difficult process. Here’s what you need to do:

  • Contact your insurance company. Ask about their process for taking out a loan against your policy’s cash value. You’ll need to find out whether your policy is eligible for a loan and, if so, where its cash value currently sits.
  • Decide how much to borrow. Your insurance company may have a limit on the percentage of your cash value that can be borrowed. Keep in mind that the more you take out, the higher risk you run of interest accruing interest to the point that the loan balance exceeds your policy’s cash value.
  • Request the loan. You may need to verify your identity and fill out some paperwork. Your insurance company should have the amount deposited in your bank account within a few days.

The takeaway

  • Whole life insurance policyholders who have been paying premiums for several years may be able to take out a loan against their policy’s cash value.
  • Life insurance loans generally have lower interest rates and more flexible repayment terms than traditional financing methods.
  • If you pass away before repaying your life insurance loan, the remaining balance will be subtracted from the death benefit that your beneficiaries receive.

Compared to high-interest options like credit cards and payday loans, taking out a life insurance loan can be a low-risk alternative to make ends meet in a pinch. While there are a few pitfalls to look out for, such as losing coverage due to the loan balance exceeding the policy’s cash value, borrowing from life insurance has several benefits and can be a great option for those with an eligible policy.

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