Read This Before You Borrow Against Your Life Insurance Policy

Sean McGinn is an assistant director of Product Positioning in the Insurance Solutions department at Northwestern Mutual.

Planning for the people you love isn’t always easy, but it’s an important part of caring for their future. One way to plan is with permanent life insurance. It’s designed to be a safety net that provides money to loved ones when you pass away.

But permanent life insurance has additional benefits that can be really powerful. For example, this type of life insurance accumulates cash value that makes your policy a flexible financial tool.

As the years pass, the cash value can be a source of funding for emergencies or opportunities while you’re still living. But it’s important to know what you’re doing and to understand the tradeoffs. Let’s review how policy loans work, how you repay them, and the pros and cons of borrowing against your policy, so you can decide if a loan is right for you.

What is a life insurance loan?

As mentioned above, permanent life insurance (like whole or universal life insurance) accumulates cash value as you pay premiums. One common way to make use of that cash value is to borrow against it. This can help with things like an emergency expense, college costs, or even making it through down markets in retirement. After all, no matter how much you plan, life will probably surprise you now and then.

It can take several years—perhaps ten—to build up enough cash value through your premium payments. Once you can hit that point, you can borrow against it for any financial need.¹ You can get the money quickly but need to have a plan to repay it with interest. Without disciplined repayments, loans can quietly compound and eventually become overwhelming.

How do life insurance loans work?

A policy loan gives you quick access to cash should you need it. You simply fill out a form, and then the insurance company sends you the money within a couple of days.

To keep yourself healthy financially, remember that you’re taking a loan against your policy. That means:

• Interest accrues on the loan and is paid to the insurer.
• Until you repay it, the loan reduces the death benefit payout to your loved ones.
• The loan can affect the dividend you may receive on the policy.²
• If the loan grows too large, it can jeopardize the policy.

Another area to be cautious about is the tax treatment of the loan. Loans generally aren’t taxable while the policy remains active (known as in force). But let’s say you hit a rough patch financially and have to give up the policy (which is known as lapse or surrender). If your policy still has an outstanding loan, the IRS may treat the loan as taxable income.

Life insurance loans typically don’t affect your credit because your policy is the collateral for the loan, and there’s no set repayment schedule. There’s no loan approval process, which means your credit score is unaffected when you get the loan. And you can borrow against your life insurance policy for any reason.

Work with a professional to make sure you have a solid repayment plan, and then do your best to stick to it.

What is the concept of “infinite banking” using life insurance?

This idea has been around for a long time, getting more attention in the last several years. Although the main reason for owning a permanent life insurance policy is the death benefit, the “infinite banking” concept refers to borrowing against the policy’s value in an effort to avoid a traditional bank loan. The effectiveness of this concept depends on many factors, including the interest rates during the loan, the need for the cash value to accumulate prior to being able to access, and the ability to manage the loan to help avoid surrender of the policy and potential negative tax consequences.

Repaying a life insurance loan

Repaying a policy loan is also easy and flexible. Unlike most traditional loans, a policy loan doesn’t have a fixed repayment schedule. If you want to make a large payment one month, you can. If you want to pay nothing one month, you can. But it’s worth noting that your loan will accumulate interest. That means that if you don’t make payments, the balance will increase over time.

If you have a loan against your policy when you die, the death benefit will be reduced by the amount of the loan. And if the loan balance gets too high, the insurance company will surrender or “lapse” your policy to pay the loan, which can result in a negative tax consequence (see more below). Once you repay your loan, the full benefits of the policy will be restored.

How much can you borrow against a life insurance policy?

Different policies come with different rules, but you can typically borrow most of your cash value. But, as mentioned above, if your loan amount gets too high, it’s possible that the insurance company will surrender your policy to pay off the loan. Depending on your situation, you could then owe tax.

When can you take out a life insurance loan?

As soon as you accumulate sufficient cash value, you can borrow against the policy. But it could take 10 years or more for your policy to build enough cash value for a loan to be feasible. If you’re looking to access funds, you may want to talk through options with a financial advisor. Life insurance loans can be a great option for fast cash when you hit a milestone or have to deal with a surprise, but there are cases where an alternative could make more sense.

Which life insurance policies can you borrow against?

You can borrow against any policy that accumulates cash value, like whole life or universal life. If you have a term life insurance policy, your policy won’t accumulate cash value. Because of that, you can’t take a loan against term life insurance. The ability to take a loan is one of the major advantages of a permanent life insurance policy compared with a term policy.

What are the tax implications of borrowing against life insurance?

When you sell traditional investments, you owe taxes on any capital gain. That gain is money you made above the basis—usually the amount you paid in. If you surrender a life insurance policy, you’ll also owe taxes on the cash value growth based on your income tax rate.

However, in most cases you won’t owe taxes if you’re simply taking a loan against your insurance, so long as your policy stays in place.³ This can be particularly beneficial in retirement if you’re working to manage the taxes you owe in a particular year.

But it’s important to talk with your financial advisor, as there can also be negative tax consequences if your loan balance gets too high. If you don’t make payments on a policy loan, interest will accrue—and if the interest isn’t paid, it will be added to your loan balance, increasing the amount you owe.

At some point, if you don’t make payments on the principal or interest, the loan balance could become equal to your policy’s cash value. Once that’s the case, your policy will lapse. At that point two things will happen. First, the insurance company will surrender your policy. Second, the company will use the cash proceeds from the surrender to pay off the loan balance. In such cases, you most likely won’t receive any surrender proceeds from the policy.

It’s important to understand the tax consequences of this scenario.

First, let’s think about a policy surrender and assume there’s no loan. Say you have a policy with a cash value of $200,000, and the basis that you paid is $90,000. If you were to surrender your policy and walk away with the cash value, you’d recover the $90,000 you paid in, tax-free. The $110,000 gain, however, would be taxed as ordinary income. Assuming a 30 percent tax rate, that’d result in you owing the government about $33,000. So, after tax, you’d have $167,000.

Now let’s add the loan. Say you borrowed $100,000 and never made any repayments. The interest would compound, and in the following years, if you never repaid any of the loan interest and/or principal, your total loan balance would approach the total cash value. If the total loan balance got too high, the policy would lapse, and the company would terminate, or surrender, your policy and use the proceeds to pay off your loan.

From a tax perspective, the first step (the policy surrender) is treated the same whether the money is used to repay the loan balance or taken as cash with no loan involved. You would still owe $33,000 in income tax—but you wouldn’t receive any surrender proceeds from the policy to help you pay that tax.

What are the pros and cons of life insurance loans?

Now that you know more about how a life insurance policy loan works, you might wonder whether it’s a good idea. Here are some of the major considerations to talk through with your financial advisor.

Pros:

• You have easy and fast access to funds—as long as you have the right type of policy, such as whole life, and the policy has accumulated the cash value.
• You can use the money for any reason and there’s no credit check.
• The money isn’t considered taxable income for federal and state taxes.
• Repayment can be flexible compared with a bank loan that has a fixed repayment schedule.

Cons:

• The loan decreases the death benefit to your loved ones until it’s repaid.
• The loan accumulates interest like other types of loans.
• You could lose the insurance policy if you can’t pay back the loan—and you’ll owe tax on any gain.

Should I borrow against my life insurance policy?

Your Northwestern Mutual financial advisor can help make sure you understand all the implications of a life insurance policy loan, and whether it’s the right option for you. Your advisor may be able to point out opportunities or blind spots that might otherwise be overlooked. Together you can see how the loan works in the context of your broader financial plan so that you’re confident in your decision.

Life doesn’t always go according to plan, but having a source of financial flexibility backed by a company built to keep its promises can help you feel more prepared for whatever comes next.

This publication is not intended as legal or tax advice. Financial representatives do not provide tax advice. Taxpayers should seek advice based on their particular circumstances from an independent tax advisor. Policyowners should consult with their tax advisors about the potential impact of any surrenders, withdrawals or loans.