Life Insurance Policy Loans

If you are the owner of a permanent life insurance policy, you may be able to borrow funds from your policy’s cash value. Term policies, which provide less expensive life insurance coverage, do not offer cash value or the ability to take policy loans.

What is cash value?

Cash value is a savings-type element that is built into a permanent life insurance policy – it acts like a tax-deferred accumulation account within the life insurance policy that earns interest over time and may become available to the policy owner for use after a period of time during which reserve funds accumulate in the background of the contract. Cash value takes time to build up in a policy. It starts at zero when the policy is first opened, then increases at a guaranteed minimum rate.

Once the cash value of a policy reaches a contractually specified level, which may take several years, the policy owner may be able to take loans against the available balance to use as their needs dictate. After a loan has been initiated, the loan balance accumulates at the rate of interest specified by the policy; loan interest rates and servicing methodologies vary by product and insurer. Participating whole life policy owners may be able to use their policies’ dividends to repay the balance of their loans, rebuilding some of their policies’ available cash value.

If the policy’s cash value reaches zero, the policy lapses and may terminate unless the policy owner repays a specified portion of the loan during any grace period provided by the policy.

How do policy loans work?

A policy owner can initiate a policy loan by contacting their insurer once the policy has accrued sufficient cash value to support the loan. Most insurers impose a cap on how much of the policy’s cash value a policy owner can borrow – at Navy Mutual, policy owners may borrow up to 75% of a policy’s available cash value. Other insurers may have different limits.

The borrowed funds are provided to the policy owner for immediate use, and consequently immediately reduce the policy’s available cash value and net death benefit. Interest begins accruing on the loan immediately. Accrued interest may be paid with the policy’s remaining cash value or by the policy owner. The policy documents may not impose any stringent rules around loan repayment, but it is normally in the policy owner’s best interest to repay their loan in full, as doing so will preserve the policy’s tax-free death benefit and protect the listed beneficiaries.

If the loan’s balance plus accrued interest grows to exceed the policy’s cash value, the policy will lapse and may terminate. This may also cause a taxable event, as the amount of the loan that exceeds the policy’s tax basis is treated as ordinary income for tax purposes.

If the insured passes away before a policy loan is repaid, a death benefit will still be paid to the policy’s beneficiaries. However, the death benefit will be reduced by the outstanding loan balance and the associated interest.

Once a policy loan has been repaid, the policy’s cash value again becomes available. This allows the policy owner to take another policy loan in the future.

Are there caveats to policy loans?

Yes, caveats to policy loans include:

• Loans immediately reduce the policy’s cash value, leaving fewer funds available to cover other costs (e.g., paying the interest on an outstanding policy loan) or for other policy loans. A loan also reduces the policy’s death benefit if it is not repaid before the death of the insured.
• If loan balances are not repaid, the interest on the loan will continue to accrue and increase the loan balance. If the total of both the loan balance and accrued interest exceeds the available cash value, the policy can lapse. In addition to leaving the insured without life insurance coverage, this may also cause a taxable event for the policy owner.
• Policy loans have the potential to impact the policy’s beneficiaries depending on the timing of the loan and the status of loan repayment at the time of the insured’s death.

However, there can be many benefits to policy loans, should a policy owner have a need to access funds quickly. These include:

• There is no credit check or formal approval process required to initiate a policy loan. If the policy has the cash value available and any time requirements have been met, getting the loan takes little effort beyond contacting the insurer and filling out a loan request form.
• The loan is provided tax free (provided the policy is not a Modified Endowment Contract).
• Policy owners can use the cash from their policy loans however they see fit. These loans are not tied to any particular purchase or purpose as would be the case if an individual financed a roofing project or took out a vehicle loan.
• Policy loans leave other assets free to grow and accrue value without being tied to the loan as collateral.
• The cash value of the life insurance policy normally keeps growing even after funds have been removed for a policy loan.
• Life insurance policy loans usually have no mandatory monthly payments. While insurers generally expect that policy loans will be repaid, there is often no mandatory minimum payment amount or required timeline that must be followed.
• Interest rates charged by insurers are generally lower than the interest rates charged by credit card companies or by banks for personal loans.

How do loans work at Navy Mutual?

Navy Mutual’s permanent life insurance products, including Flagship Whole Life insurance, offer policy owners the opportunity to take loans from their policies’ cash value. Outstanding policy loan balances earn dividends, so taking a loan will not adversely impact the growth of the policy’s cash value.

Policy owners can borrow up to 75% of a policy’s available cash value. While Navy Mutual does not require payments to be made toward the loan principal, we do recommend that policy owners, at a minimum, make interest payments. Otherwise, interest accrues throughout the year and is added annually to the loan balance. This may cause the policy to lapse if the loan balance eventually exceeds the cash value of the policy, which triggers a taxable event.

Note that the total outstanding balance and any accrued interest on the loan at the time of the insured’s death will be subtracted from the death benefit at the time of settlement. If an individual chooses to surrender a policy during the insured’s lifetime, the outstanding loan amount and any accrued interest will be subtracted from the policy’s cash value.