Borrowing against life insurance can be an easy and quick way to get access to cash when you need it, but you’ll only be able to borrow against a permanent life insurance policy. It’s also important to remember that if you do not pay it off, the loan will reduce your death benefit. Your policy may also lapse if you fail to pay off the interest added to the loan.

How Does Borrowing Against Life Insurance Work?

Borrowing against life insurance involves using the policy’s cash value and death benefit as collateral. The value of the policy will stay intact if you pay back the loan. But, if you do not repay the entire loan before you die, the insurance company can deduct the outstanding amount and the interest you owe from the death benefit. This means that your beneficiaries will get a lower payout.

Unlike other loans, policy loans will not involve a credit check or an approval process since you’re borrowing from yourself. Loan funds can be used for any purpose, and it remains tax-free if your policy stays active, as long as it isn’t a modified endowment contract.

Policy loans come with a low interest rate, and the repayment schedule is quite flexible. But you’ll have to continue making premium payments alongside loan repayment. If interest accrues and your total loan balance exceeds the cash value of your policy, it can lapse, and you may owe taxes on the amount you borrowed.

How Much Can You Borrow?

Insurance companies have policies in place to determine how much you can borrow against your life insurance policy. In most cases, you’ll be allowed to borrow up to 90% of the cash value. An important point to keep in mind is that if you want to keep the policy active, you’ll need to have sufficient cash value in the contract so that it’s not affected by the loan and any interest that it’ll accrue. There’s no fixed repayment schedule for the loan, but the balance will accumulate interest, and you’ll need to repay the loan before you die. Your policy will either have a variable rate tied to the market or a fixed rate that is specified in your policy. Generally, rates are lower than credit card or personal loan interest rates.

Policies You Can Borrow From

You’ll only be able to borrow against cash-value life insurance policies. With these policies, a part of the premium you pay goes towards building a cash value, which works as an investment account. Once your policy has accumulated a cash value over a certain threshold, you’ll be able to borrow against it.

The types of policies you can borrow against include:

  • Universal life insurance
  • Whole life insurance
  • Variable life insurance

You cannot borrow against a term life insurance policy, but you can convert it to a permanent policy. Once it accumulates sufficient cash value, you may be able to borrow against it. Check to see if your insurance product qualifies for this option.

Pros and Cons of Borrowing Against Life Insurance

Borrowing against life insurance can give you access to funds quickly in case of an emergency, but it comes with a few risks. It’s important to weigh the pros and cons to ensure you’re making an informed decision.

Pros

  • You don’t need to meet any qualification requirements or credit check to borrow money.
  • You can spend the money you borrow in any way you like.
  • There’s no set repayment schedule, so you can pay back the loan when it’s convenient. But, the amount you owe should not exceed the cash value of your policy.
  • Your policy will continue to grow as the cash value is only used as collateral.

Cons

  • You’ll only be able to borrow if you have sufficient cash value in your policy, which can take years to build.
  • If you don’t repay your loan or if the policy lapses, there may be tax consequences for the amount you borrowed.
  • If you fail to repay the loan before you die, your coverage amount may be reduced, and your beneficiaries will receive a reduced death benefit.
  • There’s no set repayment schedule, but the outstanding loan balance will continue to accrue interest until you pay it off in full. This may increase the total loan cost, and your policy may lapse.

Debt expert and founder of Greenbacks Consulting, Teresa Dodson, cautions consumers against using this type of loan unless it’s absolutely needed. “I wouldn’t recommend doing this unless you are in a dire situation where you'll be homeless if you don't,” Dodson explains. “Or if something in your life has changed where you have no one who’ll need this benefit if you die,” she adds.

What Are the Alternatives?

There are several alternatives to borrowing against life insurance if you’re in need of funds. You can use the cash value of your policy in several ways:

  • One option is to make a permanent withdrawal from your universal life insurance policy. You won’t have to pay it back, but it will reduce the policy’s death benefit and cash value. You’ll be able to withdraw tax-free any amount that you’ve paid into your policy thus far.
  • Some cash value policies will also allow you to use the money from the cash value to pay your premiums.
  • You can terminate your policy to get a cash surrender value. The payout is the total cash value of the policy minus termination fees. If your policy has accrued good value and your beneficiaries do not need a death benefit, this may be a good option.  

Is Borrowing Against Life Insurance a Good Idea?

Before you borrow against life insurance, weigh all your options carefully. There are some situations where a policy loan may be beneficial:

  • If you need an emergency loan to cover an unexpected expense, a policy loan offers you funds at a lower interest rate.
  • If you have poor credit and are unable to get a bank loan, you can get a policy loan without a credit check.
  • If you have high-interest debt, you can use the proceeds from the policy loan to pay off these debts. Typically, you’ll be able to get a policy loan at an interest rate of 5% to 8%, but it can also be lower in some cases.

Consider your unique financial situation and consider all alternatives to determine if this is the right option for you. Speak to an insurance agent or a financial advisor to help identify the right course of action. Most importantly, ensure that you’ll be able to make payments on the loan along with the monthly premiums comfortably so your policy doesn’t lapse.