What is a Policy Loan?
A policy loan is financing that someone with a permanent life insurance policy can take out using their policy’s cash value as collateral. Any unpaid loan amount and interest will be subtracted from their death benefit when they pass away.
Which life insurance policies offer loans
In order to be eligible for a policy loan, you need two things:
A life insurance policy with cash value. In other words, you’ll need a permanent life insurance policy to get this option. Term life insurance doesn’t have a cash value component, so you can’t take a policy loan against term coverage.
Sufficient cash value. Insurance companies require your cash value to accrue to a certain level before they’ll offer you a policy loan. You’ll need to hold the policy for a specific number of years to be eligible, or you’ll need to have your cash value accumulation reach a specific sum. In many cases, policy loans won’t become an option until you’re several years into your policy.
How life insurance policy loans work
When you take a loan through your life insurance, you aren’t actually borrowing the cash value within your policy. Instead, the life insurance provider issues your loan proceeds and your cash value stays in place, acting as collateral for the loan.
Because the cash value backs your loan, it’s considered a secured loan. And that means you’ll get a lower interest rate than you would with an unsecured loan like a personal loan.
Unlike most other loan types, many policy loans offer flexible payment schedules. You may be able to make payments only when you’re able or choose to do so, for example.
That said, you’ll want to keep an eye on what you owe. When you die, any outstanding loan amount (including accrued interest) eats into your death benefit. In other words, your life insurance provider will subtract what you owe from your policy benefit before they distribute it to your beneficiaries.
There’s a silver lining there. Because the life insurance company is confident they can recoup any outstanding loan amounts, they don’t require a credit check or any involved application process. If you’re eligible for a policy loan, you can usually secure one pretty quickly and easily — without implications for your credit score.
If you ever need cash quickly, a policy loan will generally give you a faster, lower-interest option than other types of financing.
Policy loan interest
Even if you decide to stop making significant payments toward your policy loan for a season, it’s generally advisable to at least keep the interest paid up. If the interest on your policy loan accrues to the point that the loan amount plus interest nears your cash value, you risk an unwelcome situation.
Specifically, because the cash value serves as the loan’s collateral, you can’t be in a situation where you own more than you have accrued in cash value. If you approach that point, your life insurance policy can lapse. Not only does this mean that you’ll lose the death benefit for your beneficiaries, but it also carries tax implications. If you took a loan on any cash value amount that exceeds what you’ve paid in premiums, that money could be subject to taxation.
Ultimately, a policy loan can give you a way to use your life insurance cash value as a living benefit. But the flexible repayment terms can be a double-edged sword. Keep an eye on your outstanding balance — especially the interest — to protect your policy as you carry the loan.