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What you need to know about borrowing from life insurance

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Ariel Skelley/Getty Images

The main benefit of life insurance is having a financial cushion that can provide your loved ones with a sense of security after you pass away. But there may be times when you need access to cash to reach goals that are more immediate. In these situations, you might consider borrowing against life insurance.

In addition to providing a death benefit, your life insurance can be a valuable asset. In some cases, you can take out a loan against a life insurance contract to get much-needed cash quickly. Doing so can offer access to tax-free money that you don't necessarily need to repay.

It's important to understand the pros and cons before you borrow against life insurance. For instance, you may inadvertently cause your contract to lapse, which may have undesirable consequences. Plus, unpaid loans reduce the amount your beneficiaries receive as a death benefit. Here's a look at what's involved with a life insurance loan so you can make an informed decision.

Can I borrow against my life insurance contract?

If your life insurance has a cash value, you may be able to borrow against the contract. Whole life, universal life insurance and variable universal life are types of permanent coverage that usually have a cash value component. That cash value helps to fund the costs of insurance while serving as a pool of funds you may be able to access during your lifetime. When you have excess cash value, you're welcome to leave the funds in your contract to help keep coverage in force. But you also might borrow against that money if the need arises.

Term insurance coverage lasts for a specific length of time and does not have cash value, so you cannot borrow against term life insurance.

Pros and cons of borrowing from life insurance

There are benefits and challenges to borrowing from life insurance. It can get complex because it is a contract and there are requirements to follow. Here is a breakdown of the benefits and challenges.

Pros of borrowing from life insurance

There are several benefits of borrowing against your life insurance, including the following:

  • Flexibility. You can use the money for anything you want. Unlike a home or auto loan, the loan is not tied to any specific purchase.
  • Speed. Funds can arrive in your bank account within days. You don't need to wait for lender underwriting or credit checks. The money is already in your contract for collateral, so it's just a matter of processing your request.
  • Repayment options. You can repay as quickly or as slowly as you want; it may even be the case that you don't repay it at all. But be mindful of any interest charges as well as the impact on your beneficiaries.
  • Competitive rates. Since the cash value provides collateral, there's less risk, resulting in potentially favorable interest rates.
  • Cash value remains in the contract. Because you don't pull funds from your cash value (the cash value is simply collateral), all of your cash value continues to earn interest. As a result, you can offset some of the borrowing costs associated with any outstanding loan balance.
  • Tax-free money. Money you borrow from your life insurance contract doesn't require paying income tax. As long as the contract is not a Modified Endowment Contract (MEC).

Cons of borrowing from life insurance

If borrowing seems like a feasible option for you, take the time to understand the potential drawbacks, such as the following:

  • Contract lapse. If you don't maintain a sufficient cash value, your contract could run out of money and lapse. If that happens, you would lose coverage and potentially owe taxes and penalties on any money you've borrowed.
  • Interest charges. You will have to pay interest to your insurer, and the loan balance can grow over time—especially if you don't make payments.
  • Reduced death benefit. Any outstanding loan balance at the time of your death will be deducted from the death benefit. As a result, your beneficiaries could receive less than the face value.

How much can I borrow from my life insurance contract?

Insurance companies set policies on how much you can borrow. In many cases, you can take up to 90% of your cash value. But keep in mind that you need to maintain a sufficient cash value in your contract that is unaffected by loans to maintain the policy and keep it active.

How soon can I borrow against my life insurance?

You can generally borrow against your contract after the contract has been in force long enough to accumulate meaningful cash value. However, you'll want to check with your insurer for details. In some cases, it can take several years before your cash value grows to a substantial amount.

How do I repay my life insurance loan?

You have several options when it comes to repayment. You can make lump-sum or periodic payments. The amount and timing are typically up to you, so you can choose to repay when it makes the most sense. If your contract pays dividends, you also might be able to direct any dividend income toward loan repayment, reducing the amount you'll need to pay out-of-pocket.

While you don't necessarily have to make any repayments, it's wise to do so if you want your beneficiaries to get the full death benefit. Any unpaid balance will reduce what your loved ones receive after you pass away. If the unexpected were to happen and you pass away before repaying the loan, the amount owed would be deducted from the death benefit.

Also keep in mind that interest charges are added to your loan balance over time. If you don't make any payments, those charges could eventually deplete the cash surrender value, causing the contract to lapse.

What happens if my contract lapses?

When a permanent life insurance contract lapses, you lose coverage. You might owe taxes (and tax penalties, depending on the situation) if the amount you received exceeds the amount you paid into a contract.

Learn more and decide what's right for you

Now that you understand how loans against life insurance work, it's time to review the details of your contract and review your strategy with your financial advisor. Ask your insurer about the current borrowing rates, their other policies and how much you can potentially borrow. You may not owe taxes on a life insurance loan as long as you meet IRS requirements. Be sure to discuss your strategy with a tax professional and monitor the loan until you pay it off entirely.

To learn more about loans from your life insurance, speak with a Thrivent financial advisor. An experienced agent can walk you through the details and help you formulate a strategy tailored toward your unique goals.

Loans and surrenders will decrease the death proceeds and the value available to pay insurance costs which may cause the contract to terminate without value. Surrenders may generate an income tax liability and charges may apply. A significant taxable event can occur if a contract terminates with outstanding debt. Contact your tax advisor for further details. Loaned values may accumulate at a lower rate than unloaned values.

Thrivent and its financial advisors and professionals do not provide legal, accounting or tax advice. Consult your attorney or tax professional.