Can I Use a Life Insurance Policy to Get a Loan?

Look, borrowing money can feel like navigating a maze, especially when it involves something as personal as your life insurance policy. With UK estate planning getting more complicated and inheritance tax (IHT) rules tightening, many people wonder: Can I use a life insurance policy to get a loan? The short answer is yes—but like most things in finance, it’s not that simple. Let me walk you through the nuts and bolts, the traps, and the savvy moves.

The Growing Complexity of UK Estate Planning and Inheritance Tax

The landscape of UK estate planning isn’t what it was a decade ago. HM Revenue & Customs (HMRC) has been watching closely, cracking down harder on loopholes and aiming to make sure tax is paid where it’s due. The standard nil-rate band for pass on wealth to children IHT currently stands at £325,000 per individual. If your estate—including your house, savings, and other assets—exceeds this, your beneficiaries could be facing a hefty 40% tax bill on the amount over that threshold.

Here’s where life insurance steps into the ring.

Using Life Insurance as a Tool to Pay IHT Liabilities

When you die, the estate pays inheritance tax if it’s above those thresholds. Sounds simple, right? Well, here’s the kicker: many families are left scrambling to find liquidity fast, which might mean selling homes or other cherished assets to cover the tax bill.

A carefully arranged life insurance policy can provide the cash needed to settle IHT, ensuring your assets can pass intact to your loved ones. But the key is understanding the type of policy and how it fits within your overall plan.

The Difference Between Whole of Life, Term, and Family Income Benefit Policies

Let’s break down the main types of life insurance policies used in estate planning:

Whole of Life Insurance: This type lasts your entire life as long as you keep paying the premiums. Because it’s guaranteed to pay out eventually, it is often used explicitly to cover IHT liabilities. A key feature is the cash value element, meaning it accumulates a surrender value over time that can be borrowed against. Term Insurance: This provides cover for a specified period—say 20 or 30 years. If you die within that term, the policy pays out, but if you outlive it, it’s worthless. There’s no cash value or ability to borrow against it. It’s cheaper but less flexible. Family Income Benefit: Instead of a lump sum, this pays a regular income to your dependents if you die during the term. Not typically used for IHT planning or borrowing.

Borrowing Against Whole of Life Policies: How Does That Work?

Whole of life policies build what’s called a cash value—think of this as a savings pot accumulating inside your insurance. Many providers allow you to take out a policy loan using this cash value as collateral. Sounds simple, right?

Here’s the catch: while you are effectively borrowing against your policy, the outstanding loan and interest get deducted from the life insurance payout when you die. That means your beneficiaries get less money if you don’t repay the loan during your lifetime.

Using Life Insurance as Collateral for Loans in the UK

In the UK, the concept of borrowing against whole of life policy or policy loans isn’t as widespread as in the US, but it exists. If you need quick access to funds, this can be a way to raise money without applying for a traditional loan.

Keep in mind:

Interest rates on policy loans can be lower than personal loans or credit cards, but they still add up. The loan reduces the guaranteed amount your family will receive when the policy pays out. Not all UK insurers offer loans on life policies, so check the policy details carefully.

So, if you’re thinking about using life insurance as collateral, make sure the policy permits this and understand the long-term impact on your estate.

The Critical Importance of Writing Life Insurance Policies in Trust

Here’s where I see people make a costly mistake: they buy life insurance as part of their estate plan but don’t put the policy into a trust. Ever wondered why that is such a big deal?

If the policy isn’t held in trust, it becomes part of your estate when you die, meaning:

The proceeds could be delayed because the estate needs to be probated. The payout may be subject to the same inheritance tax you were trying to avoid paying with the policy. Your beneficiaries might have less control and face unnecessary complications.

By setting up a trust, the policy proceeds go directly and immediately to the named beneficiaries, bypassing the estate. This is crucial to ensuring the money is there when needed—for example, to pay the IHT bill promptly without tying up the house or other assets.

Annual Gifting Allowance and Life Insurance

While we are talking about estate planning, let me remind you about the annual gifting allowance set by HMRC, which stands at £3,000. You can gift this amount each tax year without it impacting your inheritance tax thresholds. This can be a useful tool to reduce your estate’s value, but it’s only part of a bigger strategy.

Practical Example: How Life Insurance Can Pay Your IHT Bill

Item Value Property Value £600,000 Other Assets £200,000 Total Estate Value £800,000 IHT Nil-Rate Band £325,000 Taxable Estate £475,000 Inheritance Tax Due at 40% £190,000

In this example, without liquid funds to cover the £190,000 IHT bill, the family would need to sell off assets. A whole of life insurance policy held in trust, sufficient to cover this amount, can pay this tax liability on death, preserving the estate intact.

Common Mistakes to Avoid

Not Writing Your Policy in Trust: As I mentioned, this can lead to delays and unintended tax bills. Choosing Term Insurance to Cover IHT: Term insurance doesn’t build cash value and can expire before the tax liability arises, potentially leaving a gap. Ignoring Policy Loan Impacts: Taking out a loan against your whole of life policy without understanding the reduction in payout can hurt your beneficiaries.

Wrapping It Up

Using life insurance to get a loan or as a tool in your estate plan is a viable strategy, but it demands careful consideration. Whole of life policies offer cash value that can be borrowed against, but the reduced death benefit must be factored in. Term policies are simpler but lack collateral value.

Here’s the kicker: always put your life insurance policies in trust to keep the payout outside your estate and ensure smooth, tax-efficient transfers to your beneficiaries. Mixing your estate planning with HMRC's complex rules, the £3,000 annual gifting allowance, and the right insurance products can protect your money and your loved ones’ futures.

If you’re unsure how to start or want to review your existing policies and estate plan, have a chat with a financial advisor who knows the ins and outs—and knows how to speak human, not just financial gobbledygook.