What Are Policy Loans?
Policy loans are a type of loan issued by an insurance company that uses the cash value of a permanent life insurance policy as collateral. This financial mechanism falls under the broader category of Insurance and Personal Finance, offering policyholders a means to access liquidity without fully surrendering their coverage. Unlike traditional bank loans, policy loans do not typically require a credit check or a formal application process, as the policyholder is essentially borrowing against their own accumulated funds within the insurance contract20. The availability and terms of a policy loan depend on the specific type of policy, such as whole life insurance or universal life insurance, which accumulate cash value over time.
History and Origin
The concept of borrowing against the cash value of a life insurance policy gained prominence due to a demand for liquidity, especially during periods of financial stress. Early forms of insurance date back centuries, with the idea of collective risk management evolving over time. In the United States, modern life insurance companies began to flourish in the 1800s. The critical development that led to the widespread adoption of policy loans occurred by the 1930s. The economic hardships of the Great Depression underscored the importance of accessible funds. This environment spurred the development of specific provisions within whole life insurance policies that allowed policyholders to borrow against their accumulating cash value, providing a vital source of funds without the need to surrender their policies19. This feature highlighted the dual nature of permanent life insurance as both a protection tool and a potential source of accessible capital.
Key Takeaways
- Policy loans allow policyholders to borrow against the cash value of a permanent life insurance policy.
- The loan amount is typically not taxable as income, provided the policy remains in force and certain conditions are met, such as not exceeding the premium paid18,.
- Repayment of a policy loan is flexible, with no mandatory schedule, but interest accrues and an unpaid loan reduces the death benefit paid to beneficiaries17.
- If the loan and accrued interest exceed the policy's cash value, the policy can lapse, potentially leading to a taxable event for the policyholder16.
- Policy loans do not usually require a credit check and do not appear on personal credit reports15.
Interpreting Policy Loans
Policy loans represent a unique financial tool that can be interpreted as a self-funded line of credit. When a policyholder takes a policy loan, they are not withdrawing funds directly from their cash value in a way that permanently reduces it, but rather borrowing money from the insurance company, using the policy's cash value as collateral. The cash value continues to grow, potentially on a tax-deferred growth basis, even while the loan is outstanding, although the portion used as collateral may earn a different or reduced interest rate depending on the policy terms.
The amount available for a policy loan is typically a high percentage, often up to 90% or 95%, of the policy's cash surrender value14. Policyholders should understand that while repayment is flexible, the loan balance, including accrued interest, will reduce the death benefit if not repaid before the insured's passing. This means that beneficiaries would receive a lower payout.
Hypothetical Example
Consider Maria, who purchased a whole life insurance policy 15 years ago. Her policy has accumulated a cash value of $75,000. She encounters an unexpected medical expense of $30,000. Instead of taking out a traditional bank loan or using a credit card, Maria decides to take a policy loan.
She contacts her insurance provider and requests a loan of $30,000. Since her policy has sufficient cash value to serve as collateral, the loan is approved quickly without a credit check. The insurance company charges an annual interest rate on the loan, say 5%. Maria has the flexibility to repay the loan over time or not repay it at all.
If Maria repays the $30,000 loan plus accrued interest, her policy's death benefit and cash value remain intact as they were before the loan. However, if she chooses not to repay the loan, the $30,000 plus any accumulated interest will be deducted from the death benefit paid to her beneficiaries upon her death. For instance, if her policy had a $250,000 death benefit and the outstanding loan with interest totaled $32,000, her beneficiaries would receive $218,000 ($250,000 - $32,000).
Practical Applications
Policy loans offer practical applications for individuals seeking flexible access to capital without disrupting their broader financial planning. They are often considered for short-term liquidity needs or emergency funding, given their ease of access and lack of stringent repayment schedules13. For example, a policyholder might use a policy loan to cover unexpected medical bills, bridge a gap in income, or fund a significant personal expense.
In estate planning, policy loans can also play a role. If an estate faces liquidity challenges, such as covering estate taxes, a policy loan could provide the necessary funds, ensuring that assets like real estate or businesses do not need to be liquidated quickly or at a discount to meet financial obligations. Research also suggests that households tend to use policy loans for temporary financial needs, while longer-term financial issues might lead to policy surrender12,11.
Limitations and Criticisms
While policy loans offer flexibility, they come with important limitations and criticisms. A primary concern is the accrual of interest rate on the loan. If the interest is not paid, it is typically added to the loan principal, which can cause the loan balance to grow significantly over time10. If the outstanding loan balance, including accrued interest, eventually exceeds the policy's cash value, the policy can lapse. This lapse can have significant negative consequences, as the policyholder loses their insurance coverage, and any gains in the policy (the difference between the loan amount and the premium paid) may become taxable income.
Another criticism is the reduction of the death benefit. If a policy loan is not repaid before the insured's death, the outstanding loan amount and any accumulated interest are deducted from the death benefit, reducing the amount paid to beneficiaries9. This can undermine the original purpose of the life insurance—to provide financial protection for dependents. Furthermore, while policy loans are generally not taxable, this tax-free status can be jeopardized if the policy lapses due to an unpaid loan, particularly if it is classified as a Modified Endowment Contract (MEC) under IRS rules. According to IRS Notice 2016-63, which provides guidance on life insurance contracts under Section 7702, changes to policies, including those affecting cash value, can impact their tax qualification. 8The IRS specifically outlines tax implications for policies that lapse with outstanding loans, where the amount borrowed exceeding premiums paid becomes taxable income. 7Academic research suggests that factors like household income shocks can lead to an increased demand for policy loans, highlighting their role as an emergency fund but also potentially increasing the risk of policy lapse if not managed carefully,.6
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Policy Loans vs. Cash Value Withdrawal
Policy loans are often confused with direct cash value withdrawals, but they operate distinctly. When a policyholder takes a policy loan, they are borrowing money from the insurer, using the policy's cash value as collateral. The policy remains in force, and the cash value continues to accrue interest or dividends, although the portion used for collateral may have its growth adjusted. The loan carries an interest rate, and non-repayment reduces the death benefit.
In contrast, a cash value withdrawal directly removes funds from the policy's cash value. This permanently reduces the cash value and, consequently, the death benefit. Unlike a loan, a withdrawal does not need to be repaid and does not accrue interest. However, withdrawals exceeding the amount of premiums paid into the policy may be subject to income tax. Policy loans are generally tax-free upon receipt, while withdrawals may not be.
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FAQs
Q: Are policy loans taxable?
A: Generally, policy loans are not considered taxable income as long as the permanent life insurance policy remains in force. The Internal Revenue Service (IRS) views these as a loan against the policy's own funds rather than a distribution of gains. However, if the policy lapses or is surrendered with an outstanding loan, the amount borrowed that exceeds the premiums paid into the policy may become taxable.
Q: Do I have to repay a policy loan?
A: Repaying a policy loan is typically not mandatory and there is no set repayment schedule, offering significant flexibility. However, interest rate accrues on the outstanding loan balance. If the loan and accrued interest are not repaid, they will be deducted from the death benefit paid to your beneficiaries upon the insured's death.
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Q: What happens if I don't repay my policy loan?
A: If you do not repay your policy loan, the outstanding balance, including accrued interest, will reduce the death benefit amount that your beneficiaries receive. In extreme cases, if the loan balance plus interest grows to exceed the policy's cash value, the policy could lapse, leading to the termination of coverage and potential tax consequences on any gains.
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Q: Can I take a policy loan from a Term life insurance policy?
A: No, policy loans are only available from permanent life insurance policies, such as whole life insurance or universal life insurance. This is because term life insurance policies do not build cash value, which is the underlying asset used as collateral for a policy loan.1