UPDATED: Nov 26, 2011

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Written By: Laura BerryReviewed By: Daniel WalkerUPDATED: Nov 26, 2011Fact Checked

No, you cannot take a loan from a term life insurance policy. The sticking point with taking out a loan against your life insurance policy is that it must be a policy that has cash value. In other words, whole life policies and annuities have cash value because you are investing money that earns a return for you throughout the life of the policy.

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In an economy that’s making it harder and harder to procure substantial lines of credit, many people are turning to their life insurance policies in order to cover costs like college tuition and unforeseen long-term medical care. They do so by taking a loan against the cash value of their life insurance policy. They repay their life insurance policy with monthly payments in the same way they would repay a bank had they taken out a standard loan. In essence, when you do this you are acting as your own banker.

A term life insurance policy has no cash value and therefore, doesn’t allow you to take a loan against it. If you think taking a loan against your life insurance is something you may have to do in the future, you probably want to get a whole life policy or an annuity.

What’s different about term life insurance?

Term life insurance used to be the standard product when life insurance was first introduced to the market more than 200 years ago. A term life insurance policy essentially is a contract in which the insurance company agrees to provide a death penalty as long as the subscriber continues to pay premiums. If those premiums should ever stop coming, the insurance company is no longer obligated to pay the death benefit. Term life insurance is chosen by many people because it is less costly than the alternatives.

In providing such affordable rates to subscribers, insurance companies are not able to turn around and make as much profit by investing premium dollars. Therefore, they are also not offering term life insurance as an investment vehicle, which builds cash value.

On the positive side for consumers, your beneficiaries could potentially reap a windfall of death benefits after only paying three months worth of premiums. On the downside, since there is no cash value, you could pay into the policy for 40 or 50 years and eventually see only a minimal payout upon the death of the subscriber.

How do other life insurance policies build cash value?

Under the category of “whole life,” there are several different types of policies and annuities. The details of how each type works is not relevant here; suffice it to say they are all considered investment vehicles in the same vein as stocks or bonds. With a whole life policy, you are agreeing to purchase an investment vehicle and make monthly payments for a specified amount of time, let’s say 20 years. Over the course of those 20 years, your premiums will be invested on your behalf, by the insurance company, who will then split the returns with you.

Every year you pay into the policy, your returns ostensibly add cash value to it. In theory, you could double or triple your investment within the first ten years or so if market conditions are good. That means you have extra value built into the policy because you’ll have the agreed-upon death benefit plus the extra money from the returns on your investment when it’s time to make a claim. That extra value allows you to take out a loan against your life insurance policy.

How do I take out a loan?

Typically, a loan amount cannot exceed the total cash value of your policy. To take out a loan, you simply contact your insurance company’s customer service department and request the proper paperwork. That paperwork is filled out and returned to your insurance company who will then turn around and issue you a check. One of the benefits of this type of loan is that, unlike a loan against a retirement account, this one isn’t reported to the IRS. You essentially become your own banker and are loaning yourself money from your life insurance policy.

The terms of the loan will depend on your insurance company and what the two of you agree to. Usually, you will have monthly payments as a tool to force you to repay yourself what you have taken out. Without those monthly payments, some individuals might possibly get careless and never rebuild the value of their policies.

However, at the end of the day the most important thing is that you continue to make your monthly premium payments on time. If you should miss several monthly premiums, your insurance company is under no obligation to continue carrying your policy and you could lose all of the built-in value.

What happens if I die before paying off a life insurance loan?

If you should take out a loan against your life insurance policy and then pass away before you repay it, the balance will simply be deducted from the total amount the insurance company pays to your beneficiaries. For example, if you have a $1 million policy and an outstanding balance of $30,000 on a loan, the total payment to your beneficiaries would be $970,000. Depending on the type of policy you have, taxes may then be due on the remaining $30,000 of the loan.

As a side note, the possibility of death prior to paying off a life insurance loan is the very reason why it’s not possible to take a loan that exceeds the cash value of your policy. Insurance companies willing to loan in excess of a policy’s cash value would be assuming too great a risk.

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A former insurance producer, Laura understands that education is key when it comes to buying insurance. She has happily dedicated many hours to helping her clients understand how the insurance marketplace works so they can find the best car, home, and life insurance products for their needs.

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Written by Laura Berry
Former Insurance Agent Laura Berry

Dan Walker graduated with a BS in Administrative Management in 2005 and has been working in his family’s insurance agency, FCI Agency, for 15 years. He is licensed as an agent to write property and casualty insurance, including home, auto, umbrella, and dwelling fire insurance. He’s also been featured on sites like Reviews.com.

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Reviewed by Daniel Walker
Licensed Car Insurance Agent Daniel Walker