Life Insurance Loans And Debt: What To Know Before Borrowing Against A Policy

This article is general educational information, not financial or insurance advice. Century Support Services is a debt settlement company and does not provide financial or insurance advice. Before borrowing against a life insurance policy, consult a licensed insurance professional and a financial advisor familiar with your complete financial situation, and a tax professional about lapse consequences.

Table of Contents

• What it means to borrow against a life insurance policy
• Which policies allow borrowing
• The real costs of a life insurance policy loan
• The risk to understand clearly: policy lapse
• When borrowing against a policy might make sense
• What to consider instead
• FAQ

You can borrow against certain permanent life insurance policies, but the risks are often under-explained at the point of purchase. Before using this option to address debt, understand how the loan works, what it costs, and what happens if you cannot repay it. This article is educational; Century does not provide financial or insurance advice.

Key Takeaways

• You can generally borrow only against a life insurance policy that has accumulated cash value, such as whole life, universal life, or variable life. Term life insurance generally has no cash value, and you can’t borrow against it.

• A policy loan generally does not require repayment on a fixed schedule, but unpaid interest generally compounds against the policy’s cash value. If the loan balance plus interest exceeds the cash value, the policy can lapse, with potential tax consequences.

• A lapse on a loan that has grown large can trigger a taxable event; the IRS generally treats the excess of the loan over your basis in the policy as ordinary income. Consult a tax professional.

• Borrowing against a policy generally reduces the death benefit available to your beneficiaries by the outstanding loan amount plus accumulated interest.

• Century Support Services does not provide financial or insurance advice. Consult a licensed insurance professional and a financial advisor before borrowing against any policy.

What It Means to Borrow Against a Life Insurance Policy

When you borrow against a life insurance policy, you are generally taking a loan from the insurance company using your policy’s accumulated cash value as collateral. Insurers generally do not require a credit check, income verification, or a fixed repayment schedule, because the cash value serves as security and the loan can be repaid from future payments, a voluntary repayment, or the death benefit when the policy pays out. The proceeds are generally yours to use, including to pay off debt. A key distinction from other loans is that repayment is generally not required on a schedule, but that flexibility can create a risk that accumulates quietly if the loan goes unmonitored.

Which Policies Allow Borrowing

Whole Life Insurance

Whole life policies generally accumulate guaranteed cash value over time at a stated rate, and most generally allow borrowing against a portion of the accumulated cash value. The borrowing option on whole life tends to be the most predictable, though terms vary by policy and insurer.

Universal Life and Variable Life

Universal life policies generally accumulate cash value tied to credited interest rates rather than a guaranteed schedule. Variable life policies generally tie cash value to investment sub-accounts, so the cash value can fluctuate with market performance, which affects how much you can borrow at a given time.

Term Life Insurance

Term life insurance generally provides a death benefit for a defined period with no cash value accumulation, so there is generally nothing to borrow against. If you hold only a term policy, the borrowing option generally does not apply.

The Real Costs of a Life Insurance Policy Loan

A loan against a life insurance policy is not free money. Several costs can accumulate in ways that are not always obvious:

• Interest: the insurer generally charges interest on the outstanding balance, at a rate that varies by policy and insurer. If you do not make interest payments, the interest is generally added to the loan balance.
• Compound accumulation: unpaid interest generally compounds against the balance over time. As a simplified illustration only, a loan that receives no interest payments can grow to a meaningfully larger claim against your cash value after several years; actual figures depend on your rate and policy.
• Death-benefit reduction: the outstanding balance plus accumulated interest is generally deducted from the death benefit when the policy pays out, so beneficiaries may receive less than the face value.
• Potential tax consequence on lapse: if the loan grows until the policy lapses, the IRS generally treats the excess of the loan over your cost basis as ordinary income in the year of lapse, which can be a significant tax bill.

Consult a licensed insurance professional for the specific terms of your policy and a tax professional for the tax implications before proceeding.

The Risk to Understand Clearly: Policy Lapse

A serious risk when you borrow against a life insurance policy is policy lapse, and it is often underexplained. In general terms: if you borrow against the policy and make no interest payments, the unpaid interest is generally added to the balance each year; over time, the growing balance plus accumulated interest can approach the policy’s cash value; and if the balance exceeds the cash value, the insurer may cancel the policy. At that point, coverage can disappear, beneficiaries may receive nothing, and the IRS may treat the loan balance above your cost basis as ordinary income. What began as a convenient, no-repayment-required loan can become a taxable event and a loss of coverage. Consult a tax professional and your insurer immediately if a policy may be at risk of lapse.

Also, read:

• Should You Cash Out Investments To Pay Off Debt Faster?
• Debt Settlement Taxes When Canceled Debt May Be Excluded From Income
• How Social Security Income Is Treated When You’re Working Through Debt
• What Is Debt Settlement? How It Actually Works

When Borrowing Against a Policy Might Make Sense

Borrowing against a policy is a complex decision. Some people consider it when:

• The debt being paid carries a significantly higher interest rate than the policy loan rate, and there is a concrete plan to repay the policy loan within a defined period.
• The policy has substantial cash value relative to the loan amount, so the lapse risk is more remote even if repayment is slower than anticipated.
• They have consulted both a licensed insurance professional (about policy terms) and a financial advisor (about whether this fits their full financial picture).

Even in these circumstances, the loss of death benefit and the lapse risk generally require careful monitoring for as long as the loan is outstanding.

What to Consider Instead

For consumers carrying significant unsecured debt, such as credit cards, medical bills, and personal loans, who are weighing whether to borrow against a policy, a debt settlement consultation may reveal options that do not require reducing the death benefit or risking policy lapse. Century’s debt settlement program may address eligible unsecured debt, subject to program criteria, underwriting, and state availability. Creditors are not required to settle, results vary, and the use of debt resolution services will adversely affect your creditworthiness.

Results vary. Not all consumers, debts, creditors, or accounts qualify. Creditors are not required to settle. Using debt resolution services will adversely affect your creditworthiness and may involve collection activity, lawsuits, increased balances, and tax consequences. Century is not a financial, insurance, or tax advisor.

FAQ

Can you borrow against a life insurance policy?
Generally, only certain permanent life insurance policies with accumulated cash value, such as whole, universal, or variable life, allow borrowing. Term life generally has no cash value, and you can’t borrow against it. Terms vary by policy and insurer; consult a licensed insurance professional.

What happens if you borrow against a life insurance policy and don’t repay it?
Unpaid interest generally compounds against the cash value, and if the loan balance plus interest exceeds the cash value, the policy can lapse. A lapse can end coverage and may create a taxable event on the loan balance above your cost basis. Consult your insurer and a tax professional if a policy may be at risk.

Does borrowing against a life insurance policy reduce the death benefit?
Generally, yes. The outstanding loan balance plus accumulated interest is generally deducted from the death benefit when the policy pays out, so beneficiaries may receive less than the face value until the loan is repaid.

Can you borrow against cash value to pay off debt?
You generally can, if the policy has cash value, but it carries real risks, including reduced death benefit and possible lapse with tax consequences. For unsecured debt, alternatives such as a debt settlement program may exist that do not put a policy at risk. Consult an insurance professional, a financial advisor, and a tax professional first.

Can borrowing against a life insurance policy create a tax bill?
It can, particularly if the policy lapses while a loan is outstanding. The IRS generally treats the excess of the loan over your cost basis as ordinary income in the year of lapse. A tax professional can explain how this may apply to your situation.

Resources

• IRS: Life Insurance and Taxes
• NAIC: Life Insurance Consumer Information
• CFPB: Debt Collection Consumer Rights
• FTC: Settling Credit Card Debt

Important Disclosure: This article is general educational information and is not financial, insurance, or tax advice. Century Support Services is a debt settlement company; it does not provide financial, insurance, or tax advice and is not a law firm. Policy terms, loan interest, lapse consequences, and tax treatment depend on your policy and facts; consult a licensed insurance professional, a financial advisor, and a qualified tax professional before borrowing against a policy. Debt settlement program results vary based on individual circumstances. Not all consumers or debts are eligible for a debt settlement program. Creditors are not required to settle. Century earns its fee for a settled debt only after Century obtains a settlement agreement from your creditor, you approve that agreement, and you make at least one payment to the creditor or debt collector under that settlement. Fees are assessed settlement by settlement and vary by state. Fees are not charged up front. Separate disclosed third-party account-provider fees may apply. Using debt resolution services will adversely affect your creditworthiness. References to the IRS, NAIC, CFPB, FTC, and other sources are for informational purposes only. Century Support Services is not affiliated with, endorsed by, or sponsored by any government agency. A no-obligation initial consultation involves no fee and no obligation to enroll. Century Support Services is accredited by the Association for Consumer Debt Relief (ACDR).

Jen Roberts, CFC, CDS

Jen Roberts is the Manager of Training & Development at Century Support Services, where she leads training programs and internal communications that support employee performance and client outcomes.