How Do Life Insurance Loans Work and Is One Right For You?

Permanent cash value life insurance has living benefits in addition to a death benefit. And one of the most valuable living benefits is the ability to access your equity in the policy—your cash value—by taking a life insurance policy loan.

When it comes to life insurance guarantees, more is better than fewer

When you’re dealing with your future and your family, more guarantees is better than fewer guarantees. So in this article I’m talking about whole life insurance. Whole life means the policy is one you can keep until you die, even if you live to be 120 years old. (You can’t take out a life insurance loan against a term policy anyway, because term insurance isn’t an asset; it’s simply an expense. Think about that.) We’ve got the straight skinny on the various types of life insurance in our No-Nonsense Life Insurance Guide.

A whole life insurance policy builds cash value. Cash value is money in the policy that’s yours to use. You can let your cash value grow and borrow against it—with some pretty amazing advantages compared to traditional loan sources.

Is the cash value of life insurance taxable? Are policy loans taxable?

Both your cash value and your dividends grow within your policy with no income tax due. Our article on life insurance tax advantages has more details.

You can access your equity in the policy tax-free this way:

1. Withdraw your dividends, up to your cost basis. (Your cost basis is essentially the total of the premiums you have paid, minus any withdrawals you’ve already made.)
2. If you need more, borrow against your cash value. That’s what this article is all about.

The proceeds of policy loans are not taxable. Just as you don’t pay income tax on the proceeds of a loan you take out to buy a car, you don’t pay taxes on the loans you take out from your life insurance policy.

In essence, you tell the insurance company, “Look, I’ve got X-amount of cash value. So I want to take out a loan, using my policy as collateral.”

How much can I borrow from my life insurance policy?

Because the collateral you put up for a life insurance policy loan is the death benefit and cash value of your policy, the measure of how much money you can borrow from your life insurance policy is simply the amount of cash value you have. The insurance company will retain a small portion of your cash value to keep the policy in force, and you may borrow the balance.

In practice, you can borrow somewhere between 85 and 95 percent of your cash value.

The insurance company asks no questions. They don’t run your credit. They simply cut you a check or wire the funds into your bank account, and in a few days—typically less than a week—you have your money.

And they will do this even when no banker will lend you a dime!

The company charges you interest on your loan. But it’s simple interest, not compound interest like you’d pay a finance company or credit card company. And with the right kind of participating whole life insurance policy, your cash value actually keeps growing at the same rate—even though you’ve taken out a loan. (More on that coming up.)

You pay back the loan on your terms. Make a payment. Skip a payment. It’s up to you.

You just don’t want to be reckless. Any year you don’t pay at least the loan interest, the company will add the interest to the loan balance, thus increasing your loan amount.

What happens if you let the loan balance approach or equal your policy’s cash value? That could cause the policy to lapse, and you’d have some serious tax consequences to deal with. So don’t do that.

How Life Insurance Policy Loans Work

When you take out a policy loan, the money doesn’t come directly out of your policy. It comes from the insurance company’s general fund—which is the pooled cash values of all the company’s policies. And loan payments you make are deposited back into the company’s general fund.

Here’s why it’s important that your life insurance policy loan does not come from your cash value, but rather from the insurance company’s general fund:

Your policy can continue to grow, unaffected by any policy loan you may have, if your policy has a non-direct recognition loan feature. This feature means that when the insurance company determines how much of the annual dividend “pie” goes to you, the company doesn’t “recognize”—it ignores—the fact that you have an outstanding loan. Only a small handful of companies offer this valuable feature.

Life insurance loans are different in another very important way

When you pay interest to any other lender, you don’t see that interest again. But when you pay interest on a policy loan from a participating life insurance company, you do benefit from that interest. Interest you pay is income to the insurance company, thus increasing its profits.

Dividends you receive from a participating company are based on the insurance company’s profitability. You contributed to those profits when you paid the interest on your policy loan. So when you receive a dividend, you’re receiving your share of the company’s profits, which includes a share of the loan interest you paid. Some or all of the interest you paid is actually being returned to you in the form of dividends!

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Advantages of a Whole Life Insurance Policy Loan

When you buy a big-ticket item, whether it’s a car, a home entertainment center, or a luxury cruise, you pay for it one of three ways:

1. You pay cash for it
2. You finance it
3. You lease it

Financing major purchases with a loan against a life insurance policy that meets all the requirements of the Bank On Yourself concept beats financing, leasing, and even directly paying cash.

Financing with a Bank On Yourself-Type Policy Loan Beats Traditional Financing

First, understand that “financing” includes leasing. In fact, leasing is usually the most expensive way to finance something. With a lease, you’re still using someone else’s money and paying for the privilege. And you even have to give back whatever it is you were leasing at the end of the lease—or else fork over the money to buy it outright. Of course, you could finance that buyout—but that would make leasing even more expensive.

Whether you make a major purchase with traditional financing or with a lease, the first thing that happens is somebody runs a credit check on you. Not so with a policy loan. No credit check! And you can’t be turned down for a policy loan.

Your credit rating and credit score have absolutely no effect on the interest rate you’ll be charged for a policy loan. And interest you pay on a policy loan is typically at below-market, competitive rates.

In addition to those benefits, interest you pay is calculated as simple interest, not compound interest as with other consumer credit.

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No lost opportunity cost with a Bank On Yourself life insurance policy loan

Bank On Yourself-type life insurance policies usually have non-direct recognition loan features, are issued by participating life insurance companies, and are whole life, never indexed universal life policies.

When you borrow against your policy, you continue to get the same guaranteed annual cash value increase and the same dividend, just as if you hadn’t taken the loan.

On the other hand, when you withdraw from your savings to pay cash, earnings on the money you withdraw stop instantly, and only resume—slowly—as you replenish your savings over time. You’ve lost the opportunity to earn interest until the money is placed back in your account. The amount of interest you lose is called your opportunity cost.

But not so with a Bank On Yourself-type policy loan. Your cash value continues to grow.

Because of that, there’s no opportunity cost with a policy loan. Your assets continue to grow at the same rate as if you hadn’t taken a loan.

Here’s what I mean: Let’s say you have a life insurance policy loan from one of the few companies that offer non-direct recognition policy loans. And let’s assume you pay back your loan at the same interest rate the insurance company charges.

When your loan is paid off, whether in two months or 20 years, you’ll end up with exactly the same cash value as if you hadn’t taken out a loan.

Saving money in a Bank On Yourself policy first—and then using it to make major purchases—allows your money to compound continuously even when you spend or invest it elsewhere. It solves the problem of having to continuously interrupt the growth of your money when you spend or invest it.

Doesn’t it make sense to finance major purchases in such a way that you receive the most favorable terms—with a life insurance policy loan?

In addition, consider the following benefits of life insurance policy loans:

• No credit application is required
• The loan has no effect on your credit profile or credit score
• Repayment goes to principal first, then interest, which reduces your cost
• There is no timetable for repayment! See the next section

Life insurance policy loans give you great flexibility

You have great flexibility in repaying life insurance loans. Pay back the loan on your schedule, not some bank’s schedule. Skip payments as necessary. Since any unpaid interest will be added to your loan, we recommend that you pay at least the interest due each year. Loans taken for retirement income are an exception, and I’ll comment on those in the section, Should You Pay Back Your Policy Loan? below.

When you take out your loan, your Bank On Yourself Professional can help you set up a repayment plan with payments that will automatically come out of your checking account each month.

Do you have to follow the plan you and your Professional set up? You want to be a responsible borrower, and in a perfect world, you would follow that plan. But if you have an unforeseen emergency, you’re in the driver’s seat. You call the shots. Reduce or skip a few payments, if necessary. But then get yourself back on track. After all, you’re banking on yourself. And you don’t want to cheat the banker (you)!

You’ll have continued growth of cash value—both the guaranteed annual cash value increase and the same dividend—as if you hadn’t taken the loan. And as with all Bank On Yourself-type policies, you can continue to know the guaranteed minimum cash value of your plan at any given point in time.

You’ll enjoy a typically higher return on your assets (your cash value) than with other guaranteed plans such as savings accounts, money market accounts, or certificates of deposit.

Interest you pay becomes a benefit to you as you receive dividends on your policy (see “Life insurance loans are different in a very important way,” above).

And you have immediate title to the item purchased. Use a policy loan to buy a car, and you drive out with the pink slip. Nobody will take your car away if you stop making your policy loan payments.

Can I use a life insurance policy loan to pay off other debt?

The short answer is yes. Because of all the advantages of a life insurance policy loan over traditional financing—including competitive interest rates, no lost opportunity cost (your money keeps growing just as if you didn’t have a loan, if your policy is from one of the handful of companies that offer that feature) and the incredible flexibility of a policy loan—many people choose to take loans against their life insurance policy to pay off traditional car loans, home-improvement loans, finance company loans, and so forth.

And remember, when you take out a policy loan to pay off your automobile loan, your car is no longer your collateral. That means you get your pink slip and have full ownership of your car!

With a traditional loan, you could make your payments perfectly on time, but if you fail to make just one payment—even if it’s the very last payment—the lender could theoretically repossess your car. But if your loan is a life insurance policy loan, that will never happen!

Should You Pay Back Your Life Insurance Policy Loan?

If you borrow money from a bank and don’t pay it back, what are you? In a word, you’re a thief. You’re stealing from the bank.

If you have a life insurance policy loan—which is like a loan from yourself—and you don’t pay it back, you’re still a thief. Only this time, you’re stealing from yourself, which is even dumber.

If your loan balance approaches the amount of your cash value—which you’ve pledged to guarantee the loan—the insurance company will, after giving you notice, take the cash value to pay off the loan. This can cause the policy to lapse, with serious income tax ramifications.

Plan to pay back at least the annual interest, so you’re not stealing from yourself.

As I mentioned above, an exception to this pay-back-the-interest idea is a loan taken to provide retirement income. Loans used to provide income in retirement are typically repaid by deducting the outstanding balance from the death benefit that will be paid upon the death of the insured.

A Bank On Yourself Professional can help monitor your policy loan to make sure you’re not in danger of lapsing your policy.

Download our helpful Consumer Guide to Life Insurance Policy Loans here.

Summarizing the Benefits of Life Insurance Policy Loans

It’s smart to arrange your own financing through life insurance policy loans rather than through a financial institution such as a bank, credit union, or consumer loan company, because you’re using one tool—a life insurance policy loan—that offers two critical benefits:

1. It lets you beat the banks at their own game. In fact, it makes you, in effect, your own banker.
2. It gives you a safe, predictable way to grow a nest egg, because when you use the Bank On Yourself method, you can know the guaranteed minimum value of your plan at any given time.
3. You have great flexibility. You repay your loan on your terms.
4. Your loan, like most loans, is not considered income to you, therefore it is not taxed.

Yep. It’s time to give your friendly banker his toaster back.

Continue to the Table of Contents for the No-Nonsense Life Insurance Guide