If you are low on cash and need funds to pay for college tuition, unexpected medical bills, mortgage payments or other expenses, one option is to borrow against the cash value of a permanent life insurance policy. Policy loans typically offer significant advantages over credit cards and personal bank loans, including lower interest rates, flexible repayment terms and a speedy approval process. However, these loans are not risk-free. Consider both the potential advantages and disadvantages before you take out a policy loan.

Tapping cash value

Most insurance companies allow you to borrow amounts as high as 90% to 95% of a whole or universal life policy's cash value. These loans offer several advantages over traditional loans, including:

  • Lower Costs
    Interest rates are usually lower than those available from banks and credit card companies and there are little or no fees or closing costs. In addition, although you are not paying the interest to yourself, your interest payments may benefit you indirectly if your insurer distributes a portion of its profits to policyholders as dividends.
  • Simplicity and Speed
    So long as your insurer offers loans, there is no approval process, lengthy application, credit check or income verification. Generally, you can obtain the funds within five to ten business days or less.
  • Flexibility
    Most insurers do not impose restrictions on how you use the funds. You also have the flexibility to design your own repayment schedule. You can even choose not to repay the loan. However, that can have negative consequences.
  • Credit Scores Unaffected
    Policy loans will not appear on your credit report.
  • Generally No Tax Impact
    Except as discussed below, policy loans are tax-free. They are not considered income, nor are they reported to the IRS in most cases. This is a big advantage over surrendering a policy in exchange for its cash value. Surrendering can trigger taxable gains to the extent the cash value exceeds your investment in the policy (generally, premiums paid less any dividends or withdrawals). Note that interest paid on the loan typically is not deductible.

Recognizing potential pitfalls

Before you borrow against a life insurance policy, be sure to consider the disadvantages, including:

  • Reduced Benefits for Heirs
    If you die before repaying the loan or choose not to repay it, the loan balance plus any accrued interest will reduce the benefits payable to your heirs. This can be a hardship for family members if they are counting on the insurance proceeds to replace your income or to pay estate taxes or other expenses.
  • Possible Financial and Tax Consequences
    Depending on your repayment schedule, there is a risk that the loan balance plus accrued interest will grow beyond your policy's cash value. This may cause your policy to lapse, which can trigger unfavorable tax consequences and deprive your family of the policy's death benefit.
  • Eligibility
    You can borrow against a life insurance policy only if you have built up sufficient cash value. This can take many years, so do not count on a relatively new policy as a funding source.

Dispelling a myth

There is a common misconception that you are "borrowing from yourself" when you borrow against a life insurance policy. In other words, when you pay interest on the loan, you are essentially paying yourself.

This may be true when you borrow money from a retirement plan, but it is not accurate when it comes to life insurance policy loans. In fact, you are borrowing from your insurer, pledging the cash value of your policy as collateral and paying interest to the company. Policy loans may be cheaper than traditional loans, but they are not free.

Reviewing your options

A life insurance policy loan can be an attractive, cost-effective source of funds to meet current expenses. Before you borrow against a policy, be sure you understand the risks and evaluate the relative pros and cons of traditional loans. Make sure you really need to borrow and consider whether you have alternatives, such as selling an asset or reducing expenses.

Sidebar: Retirement plan loans have hidden costs

One alternative to life insurance policy loans is to borrow from a 401(k) or other retirement plan. If your plan permits loans, you can borrow up to $50,000 or 50% of your vested account balance, whichever is less, at interest rates lower than those of comparable bank loans. You may view such loans as "free" because you are borrowing from yourself and paying interest to yourself.

In reality, borrowing from a retirement plan comes with hidden costs:

  1. You lose the tax-advantaged growth that you would have enjoyed on the funds you borrow—exchanging potential growth for a fixed interest rate. You also lose the benefits of additional contributions to the plan during the loan's term. The plan suspends contributions until the loan is repaid or because you cannot afford to make contributions and loan payments at the same time.
  2. The loan may be accelerated if you quit or lose your job. If you cannot repay the outstanding balance promptly, the transaction will be treated as a distribution subject to taxes and penalties.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.