Policy Loan Definition

What Is a Policy Loan and How Does It Work?

An insurance firm issues a policy loan, which uses the cash worth of a person's life insurance policy as collateral. It's also referred to as a "life insurance loan" on occasion.

Policy loans have always been given at a relatively low interest rate, however this is no longer the case. The money is taken from the insurance death benefit if a borrower fails to repay a policy loan.

An Overview of a Policy Loan

One option for getting emergency cash is to take out a policy loan, which uses the cash value of a life insurance policy. Only if the coverage is permanent life insurance, which can be purchased as whole life or universal life.

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TAKEAWAYS IMPORTANT

• There are some restrictions on policy loans, but they are often a rapid way to get cash.
• If you have a universal or whole life insurance policy with accumulated cash value, you can take out a policy loan.
• You have several alternatives for repaying your debt, including paying solely the annual interest or making monthly installments.
• If you don't repay a policy loan, the interest and loan amount may reduce the death benefit amount.

Unlike term life insurance, which does not accumulate monetary value, universal and whole life insurance plans do, particularly later in life. The premium is mostly used to support the indemnity benefit in the early years of the policy, but as the policy matures, the cash value grows.

As a whole life policy's cash value grows, policyholders can borrow against it and get their money without having to pay taxes on it. However, because insurers can't predict how quickly or how much cash value will grow, it's difficult to estimate when the cash value of a whole life insurance will be available for a loan. Although it is usually understood that a policy loan must be taken out after at least ten years.

Insurers also have different restrictions for how much cash value a policy must accumulate and what percentage of the cash value can be loaned. You are not actually withdrawing the cash value of your policy when you take out a policy loan. It's just being utilized as a piece of collateral.

The Benefits and Drawbacks of a Policy Loan 

Obtaining a policy loan is usually simple and quick. Because you are borrowing against your own assets, you do not need to go through an approval process. You are free to spend the funds in any way you see fit. Furthermore, the money you get is tax-free if it is equal to or less than the life insurance premiums you paid. Finally, you don't have a repayment plan or a deadline. You are not required to repay it in any way.

If the loan is not repaid before death, however, the insurance company will reduce the face amount of the policy by the amount still due when the death benefit is awarded.

If you repay the loan in full or in part, you have the option of making periodic principal payments along with annual interest payments, paying annual interest simply, or deducting interest from the cash value. Interest rates can be as high as 7% or 8% in some cases.

If a policy loan isn't paid back, interest can eat into the death benefit, putting the insurance in jeopardy of not paying out any money to beneficiaries. As a result, it's a good idea to at least make interest payments to keep the insurance loan from growing.

In the worst-case scenario, if the loan value rises above the cash value of your insurance, your life insurance policy may lapse and be cancelled by the insurance provider. The insurance loan balance plus interest is taxable income by the IRS in this situation, and the bill might be substantial.