Borrowing against life insurance cash value

In short

I once watched a neighbor stand at his mailbox, holding a letter from his insurance company and a worried look. If you are holding a permanent life insurance policy with cash value, you may be able to borrow against it without selling anything. The policy is the collateral, so the insurer usually asks for no credit check. The loan does not have a fixed repayment date, but interest grows each year, and the unpaid total can eat into your death benefit. If the loan grows past the cash value, the policy can lapse, and that can bring a surprise tax bill. Read your own policy and ask the insurer for a written loan quote before you sign anything. A little patience here can save a lot of heartache.

The whole of it

What it is

A friend of mine bought a whole life policy decades ago and never thought much about the part called cash value. Many permanent policies, such as whole life and universal life, build up a savings side over the years. Term policies do not. Part of each premium goes toward the death benefit, and part goes into a cash value account that grows slowly inside the policy.

That account is yours to use while you are alive. One way to use it is a policy loan. The insurer lends you money from its own funds and holds your cash value as security. Strictly speaking, you are not withdrawing your own money. You are borrowing the company's money, and your cash value stands behind the loan. That small difference explains most of what follows.

How it works

If you have ever borrowed from a friend, this will feel familiar, with a few quirks. You ask the insurer for a loan, and it sends a check or a deposit. Most insurers ask for a short form and not much else. Your cash value keeps growing in many policies, though some insurers credit it at a different rate while a loan is open. Your contract spells this out.

Interest is the part people miss. The borrower owes interest on the loan, and the rate is written in the policy. Some are fixed, and some float with an index. If the borrower does not pay the interest in cash, the insurer adds it to the loan balance. Then the balance grows, and interest is charged on the larger balance. That is how a small loan swells over time.

There is also no required repayment schedule in most policies. The borrower may repay whenever they like. But the insurer subtracts any unpaid loan from the death benefit when a claim is paid. So the family receives less. Plain and simple.

The danger is lapse. If the loan plus interest grows to match the cash value, the policy can end. The insurer must send notice first, and many give a grace period. But if the policy ends with a loan outstanding, the tax rules can turn the loan into taxable income. The Internal Revenue Service explains the basics of life insurance proceeds and policy loans in its publications, and the policy owner should read them or ask a tax professional.

The numbers, and where to find yours

I like a person to look at the real paper before trusting anyone's summary, including mine. Your annual statement and your policy contract hold the key numbers. The statement shows the current cash value, any loan balance, and the death benefit. The contract states the loan interest rate and whether it is fixed or variable. Look for the words policy loan provision.

You can also call the insurer or log in to its website and ask for an in force illustration. That is a printed projection showing how the policy behaves with a loan. Ask for the maximum loan available, the interest rate, and what happens to the dividends, if the policy pays any. Write down the answers and the date you got them.

Some rules come from the law and change by year, so the figures are not printed here. The federal rule that decides when a policy counts as a modified endowment contract uses a seven pay test, and loans from that kind of policy are taxed differently. The tax treatment of any gain on a surrendered policy also depends on current law. The income tax rate on a taxable gain is set by your bracket, which is the current figure, which the official source publishes each year, and the IRS page for the current year gives the verified figures. For a possible early penalty on loans from a modified endowment contract, the age threshold is the current figure, which the official source publishes each year and the percent is the current figure, which the official source publishes each year.

A worked example

Let me tell you about a woman named Carol, a nurse who is 58 years old. Carol owns a whole life policy with a death benefit of $200,000 and a cash value of $40,000. She wants $15,000 to fix her roof.

Her insurer allows a loan up to 90 percent of cash value. So 90 percent of $40,000 is $36,000, and her $15,000 request fits easily. The policy loan rate is 6 percent a year, fixed. In year one, interest on $15,000 at 6 percent is $15,000 times 0.06, which is $900.

Say Carol pays nothing. The insurer adds the $900 to the loan. Her balance at the start of year two is $15,000 plus $900, or $15,900. Interest in year two is $15,900 times 0.06, which is $954. The balance at the start of year three is $15,900 plus $954, or $16,854.

Now see what the loan does to the family. If Carol died at the start of year three with the loan unpaid, the insurer would subtract $16,854 from the $200,000 death benefit. Her family would receive $200,000 minus $16,854, which is $183,146.

Suppose instead Carol pays the $900 interest in cash each year. Then the loan stays at $15,000, and her family would receive $200,000 minus $15,000, or $185,000. The difference is small at first. Over twenty years it is not small at all.

Where it goes wrong

I have seen good people trip on this, so let me say it gently. The biggest mistake is forgetting the loan exists. Because no bill arrives, the loan feels like free money. It is not free. Interest keeps running every single day.

A second trouble is the lapse. If the loan balance climbs close to the cash value, the insurer can end the policy. When that happens, the borrower may owe income tax on the part of the loan that exceeds what was paid in as premiums. That tax can arrive with no cash left to pay it. The policy owner could be hit twice, once by losing the coverage and once by the bill.

Third, not every policy is the same. A modified endowment contract follows harsher tax rules, and loans from it may be taxed as income and may bring a penalty. A variable or indexed universal life policy can behave very differently from whole life, since its cash value moves with other things. The policy owner should ask the insurer which type of policy this is.

Fourth, dividends and growth can change when a loan is open. Some insurers pay less on the borrowed part of the cash value. Ask. Write the answer down.

Finally, a loan can cost more than a fair comparison suggests. A policy loan rate of 6 percent might sound fine next to a credit card, but a home equity line or a personal loan might cost less. The borrower has to compare the real costs, and the insurer will give a quote when asked.

Questions to answer before you leave this page

Do you know what type of permanent policy you hold, and have you read its loan provision? What is the interest rate on a policy loan, and is it fixed or variable? How much of the cash value can the insurer lend, and what would your loan do to the death benefit your family expects? Will you pay the interest each year in cash, or let it pile onto the balance, and can you live with either choice for ten or twenty years? What would happen to your policy if the loan grew until it matched the cash value, and who would receive the tax bill? Is your policy a modified endowment contract, and have you asked a tax professional what that means for a loan? Have you asked the insurer for a written quote and an in force illustration, and have you compared the cost against other ways to borrow? And if you decided not to borrow at all, would anyone in your family be worse off for it?