How to borrow against your life insurance — and should you do it?

Taking out a loan on your life insurance policy can give you a quick infusion of cash, but only if you have the right kind of policy. And even if you can borrow from your policy, that doesn't mean you should. CNBC Select explains how life insurance loans work and what you need to consider before requesting a loan from your insurer.

• How to take a loan from life insurance
• How a life insurance loan works
• What to consider before borrowing against life insurance
• Bottom line

To borrow against your life insurance, you need to have a policy with cash value, which is a feature usually found in permanent life insurance policies (such as universal or whole life insurance). Term life insurance (which is the type typically provided to you by an employer) doesn't help you here, as it has no cash value.

CNBC Select recommends MassMutual if you're looking to purchase a whole life insurance policy as it has excellent records for dividends. Pacific Universal is our top pick for universal insurance and offers a range of products in this niche. Note that with both of these providers, you must purchase a policy through a financial professional.

Another requirement is to have enough cash value in your policy to use as collateral for the loan. Minimum amounts vary by the insurance company but it can take several years to build enough value to borrow against.

If you have the right policy with enough cash value, you can request a loan. Unlike traditional forms of financing, policy loans don't require a credit check or employer and income verification. You also don't need to specify the reason for taking out the money so you can use the cash for anything from medical bills to vacation expenses (although, the latter is probably not the wisest idea).

Some life insurance providers allow you to apply online, while others may require that you fill out a paper form. If you can't find any information on how to kick off the process, give your insurer a call. You might even complete the loan request over the phone, depending on your insurance provider's policies.

When you're borrowing against your life insurance policy, you're essentially borrowing from the insurer using your policy's cash value and death benefit as collateral. Since the loan is secured, the interest rate is usually lower than on traditional personal loans or credit cards. The payment schedule is flexible and you can typically extend repayment as long as you need — but it's best to stick to a regular schedule.

If you pay off the policy loan in full, the value of your policy will stay intact. However, if you pass away before you finish repayment, the balance amount plus any interest you owe could be subtracted from the death benefit, depending on your loan's particulars. This means your beneficiaries will receive less money.

Further, interest continues to accrue when you're not making loan payments. This creates the risk of the loan amount exceeding your policy's cash value. In that case, you'll likely owe taxes on the borrowed amount. The same can also happen if you terminate the policy before you finish repaying the loan.

A life insurance policy loan gives you access to cash without having to go through a credit check or even give a reason for why you need the money. Considering you can get lower interest rates than you would with most personal loans, the solution can seem appealing. But you should be aware of certain risks as well.

Pros of life insurance loans

• It's simple to borrow provided you have enough cash value — and there's no credit or income check involved.
• You can get excellent terms such as a comparatively low interest rate and no strict repayment schedule.
• It's a tax-free financing source unless you terminate the policy or end up with a loan balance higher than the cash value of your policy.

Cons of life insurance loans

• The cash value of your policy drops while you're repaying the loan. If you die before it's paid off in full, your beneficiaries won't receive the full death benefit.
• You could end up with a lapse in coverage if interest accumulates to the point where the outstanding balance exceeds the cash value of your policy.
• You could end up owing income tax on the loan amount if the balance exceeds your policy's cash value.

As you can see, discipline with making regular payments and keeping up with premiums is essential when it comes to this type of loan. That's why it's best to consider a life insurance loan only when you have a solid repayment plan in mind and know that you can stick to it.

A policy loan can be a viable option when you need cash quickly. Still, it's important to fully understand what you're signing up for. Study the terms of your life insurance policy and contact your insurance agent if you have any questions. Additionally, it may be wise to speak with a financial advisor about the potential tax implications and the impact on your loved ones in case you can't repay the loan.

At CNBC Select, our mission is to provide our readers with high-quality service journalism and comprehensive consumer advice so they can make informed decisions with their money. Every insurance guide is based on rigorous reporting by our team of expert writers and editors with extensive knowledge of insurance products. While CNBC Select earns a commission from affiliate partners on many offers and links, we create all our content without input from our commercial team or any outside third parties, and we pride ourselves on our journalistic standards and ethics.

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