Borrowing Against Life Insurance With a Life Insurance Loan

Sean McGinn is an assistant director of Product Positioning in the Risk Products department at Northwestern Mutual.

Permanent life insurance is designed to be a safety net that provides money to loved ones when you pass away. But permanent life insurance offers additional benefits that can be really powerful. Over time, this type of life insurance accumulates cash value that makes your policy a flexible financial tool.

As the years pass, the cash value can be a source of funding for emergencies or opportunities. We’ll review how policy loans work, how you repay them and how to be confident that a life insurance loan is the right decision for you.

What is a life insurance loan?

As mentioned above, permanent life insurance (like whole or universal life insurance) accumulates cash value as you pay premiums. One common way to make use of that cash value is to borrow against it. This can help with things like an emergency expense, college costs or even making it through down markets in retirement. Once you’ve accumulated cash value, you can borrow against it for any financial need.¹

How life insurance loans work

A policy loan gives you quick access to cash should you need it. You simply fill out a form, and then the insurance company sends you the money within a couple of days.

Life insurance loans typically don’t affect your credit because your policy is the collateral for the loan, and there’s no set repayment schedule. There’s no loan approval process, which means your credit score is unaffected when you get the loan. And you can borrow against your life insurance policy for any reason.

Repaying a life insurance loan

Repaying a policy loan is also easy and flexible. Unlike most traditional loans, a policy loan doesn’t have a fixed repayment schedule. If you want to make a large payment one month, you can. If you want to pay nothing one month, you can. But it’s worth noting that your loan will accumulate interest. That means that if you don’t make payments, the balance will increase over time.

If you have a loan against your policy when you die, the death benefit will be reduced by the amount of the loan. And if the loan balance gets too high, the insurance company will surrender or “lapse” your policy to pay the loan, which can result in a negative tax consequence (see more below). Once you repay your loan, the full benefits of the policy will be restored.

How much can you borrow against life insurance?

Different policies come with different rules, but you can typically borrow against most of your cash value. However, as mentioned above, if your loan amount gets too high, it’s possible that the insurance company will surrender your policy to pay off the loan. Depending on your situation, you could then owe tax.

When can you take out a life insurance loan?

As soon as you accumulate sufficient cash value, you can borrow against it. But it could take 10 years or more for your policy to build enough cash value for a loan to be feasible. If you’re looking to access funds, you may want to talk through options with a financial advisor. Life insurance loans can be a great option, but there are cases where an alternative could make more sense.

Life insurance policies you can borrow against

You can borrow against any policy that accumulates cash value, like whole life or universal life. If you have a term life insurance policy, your policy won’t accumulate cash value. Because of that you can’t take a loan against term life insurance.

The tax implications of borrowing against life insurance

When you sell traditional investments, you owe taxes on any gain. If you surrender a life insurance policy, you’ll also owe taxes on the gain (money you made above the basis you paid into your policy—usually the amount you paid in). However, in most cases you won’t owe taxes if you’re simply taking a loan against your insurance, so long as your policy stays in place.² This can be particularly beneficial in retirement if you’re working to manage the taxes you owe in a particular year.

But it’s important to work with a financial advisor, as there can also be a negative tax consequence if your loan balance gets too high. If you don’t make payments on a policy loan, interest will accrue—and if the interest isn’t paid, it will be added to your loan balance, increasing the amount you owe. At some point, if you don’t make payments on the principal or interest, the loan balance could become equal to your policy’s cash value. Once that’s the case, your policy will lapse. At that point two things will happen. First, the insurance company will surrender your policy. Second, the company will use the cash proceeds from the surrender to pay off the loan balance. In such cases, you most likely won’t receive any surrender proceeds from the policy.

So, what’s the tax consequence? First, let’s discuss a policy surrender and assume there’s no loan. Say you have a policy with a cash value of $200,000, and the basis that you paid is $90,000. If you were to surrender your policy and walk away with the cash value, you’d recover the $90,000 you paid in, tax-free. The $110,000 gain, however, would be taxed as ordinary income. Assuming a 30 percent tax rate, that’d result in you owing the government about $33,000. You’d walk away with $167,000 after you paid the tax.

Now let’s add the loan. Say you borrowed $100,000 and never made any repayments. The interest would compound, and in the following years, if you never repaid any of the loan interest and/or principal, your total loan balance would approach the total cash value. If the total loan balance got too high, the policy would lapse, and the company would terminate, or surrender, your policy (step 1) and use the proceeds to pay off the loan the company gave to you (step 2).

From a tax perspective, the first step (the policy surrender) is treated the same whether the money is used to repay the loan balance or taken as cash with no loan involved. You would still owe $33,000 in income tax—but you wouldn’t receive any surrender proceeds from the policy to help you pay that tax.

Pros and cons of life insurance loans

Now that you know more about how a life insurance policy loan works, you might wonder whether it’s a good idea. Here are some of the major considerations to talk through with a financial advisor.

Pros:

• You have easy and fast access to funds (as long as you have a compatible policy, such as whole life).
• You can use the money for any reason.
• The money isn’t considered taxable income for federal and state taxes.
• Repayment can be flexible compared with a bank loan that has a fixed repayment schedule.

Cons:

• The loan decreases the death benefit to your loved ones until it’s repaid.
• The loan accumulates interest like other types of loans.
• You could lose the insurance policy if you can’t pay back the loan—and you’ll owe tax on any gain.

Deciding whether to borrow against life insurance with a life insurance loan

Your Northwestern Mutual financial advisor can help you make sure you understand all the implications of a loan. Together you can see how the loan works in the context of your broader financial plan so that you’re confident it is the right decision for you.

¹ Generally, the death benefit of life insurance policies that have not been transferred for value is received free from ordinary income tax. Estate taxes may apply. Partial surrenders of life insurance policies are treated first as tax-free distributions of the investment in the contract (aka “cost basis”) followed by taxable distributions of gain once all the cost basis has been distributed. If the policy is also a Modified Endowment Contract (MEC), partial surrenders are treated first as distributions of gain, subject to ordinary income taxation and possibly subject to an additional 10 percent penalty tax if the owner is under age 59½.  

If a policy is not a MEC, policy loans are not treated as taxable distributions at the time they are taken. Unpaid loan interest is capitalized to the loan principal, and the loan balance may grow large enough to cause the policy to lapse. If a policy lapses or is surrendered prior to the insured’s death, the loan will be repaid from the policy’s cash value and taxed as a distribution, subject to ordinary income taxation to the extent the loan exceeds the cost basis. If a policy is a MEC, loans, including capitalized loan interest, are treated as distributions at the time they are taken and subject to the same rules as partial surrenders, as described above.

² If your policy is a MEC, you may owe taxes when taking a loan.

This publication is not intended as legal or tax advice. Financial representatives do not provide tax advice. Taxpayers should seek advice based on their particular circumstances from an independent tax advisor. Policyowners should consult with their tax advisors about the potential impact of any surrenders, withdrawals or loans.