Automatic premium loans

An automatic premium loan (APL) is a policy feature that, when you miss a premium and the grace period ends, borrows enough from your policy's cash value to pay it instead of letting the policy lapse. It protects coverage during a temporary cash crunch or an oversight, but the loan accrues interest, and if it is left running it can eat the whole cash value and cause a lapse anyway.

How it works

Your policy needs enough cash value to support a loan, so APL applies to permanent insurance such as whole life and some universal life policies, not to term. Many insurers offer it as a standard provision, and others ask you to elect it on the application or by a form later. Check whether it is on in your policy; it may be off unless you opted in.

When a premium goes unpaid past the grace period (see life insurance grace periods and lapses), the insurer takes a policy loan from your cash value equal to the premium, pays the premium with it, and keeps the policy in force. The loan then:

• charges policy loan interest at the rate in your contract, either fixed or variable
• reduces your death benefit by the loan balance (plus interest) if you die before repaying it
• can reduce dividends or credited interest on the borrowed portion, depending on the insurer
• can be repaid at any time, in part or in full, with no set schedule

On each later due date, if you still do not pay, the insurer makes another loan. The balance grows with every missed premium and with interest.

When APL helps

APL is a safety net. It fits when:

• you sometimes forget or are traveling, hospitalized or between paychecks
• you expect to resume payments within months and will repay the loan
• you want coverage to continue while a decision about the policy is made, such as an in-force review

It is a better first line of defense than a lapse, because a lapse can leave you without coverage and force you to prove your health to reinstate it.

When APL is risky

A hypothetical example shows the limit. Say a whole life policy has $20,000 of cash value and a $2,400 annual premium, with a loan rate of 6%. These numbers are invented for illustration.

In this simple example the loan reaches only part of the cash value after four years, but the cash value does not stand still: if the cash value is smaller, or the premium larger, the loan catches up quickly. When the loan plus interest equals the cash value, the policy lapses. Three consequences follow:

1. You lose the coverage you were paying for.
2. A taxable gain may appear. On lapse with a loan outstanding, the loan is treated as a distribution. If it exceeds your cost basis, the excess is ordinary income, even though you received no cash. See how cash value is taxed: withdrawals, loans and surrenders.
3. A modified endowment contracts and the 7-pay test changes the tax rules. Loans from a MEC are taxable to the extent of gain, so an automatic loan could create a tax bill sooner.

For universal life, a related feature may automatically pay the monthly charges from cash value, which is a different mechanism; see why universal life policies lapse, and how to prevent it.

APL versus the other ways to stop paying

See nonforfeiture options: reduced paid-up and extended term and what happens if you stop paying life insurance premiums. If you plan to stop paying, deliberately choosing reduced paid-up or extended term is usually cleaner than letting an APL run.

What to do

1. Find out whether APL is active. Look in the policy or ask the insurer. Note which option applies at a lapse by default.
2. Set a calendar alert. Ask for an annual statement showing loan balance and cash value.
3. Pay down the loan as soon as you can, even partially, to stop interest from compounding. The policy loan calculator shows how a balance grows.
4. Decide on a ceiling. If the loan reaches around half the cash value, ask for an in-force illustration (see how to request and read an in-force illustration) and choose another path before it gets close.
5. Consider an overloan protection rider if you have one available; see overloan protection riders: how they prevent a taxable lapse.

Questions to ask your insurer

• Is the automatic premium loan provision active on my policy, or do I need to elect it?
• What is the loan interest rate, and is it fixed or variable?
• Does a loan change the dividend or the interest credited on the borrowed portion of my cash value?
• At what loan balance will you warn me before the policy lapses, and how far ahead?
• Is the policy a modified endowment contract?

Written answers belong in your file next to the policy. Insurers are generally required to send a notice before a policy lapses, and some states let you name a designee to receive it, which is worth doing if a relative helps manage your finances.

Key takeaways

• An automatic premium loan pays missed premiums from your cash value after the grace period, so the policy does not lapse.
• It is a short-term safety net, not a payment plan: interest compounds and the death benefit shrinks by the balance.
• If the loan ever equals the cash value, the policy lapses and a loan above your basis can create taxable income.
• Check whether APL is switched on and how it compares with reduced paid-up or extended term coverage.
• Repay as soon as possible, and review the policy with an in-force illustration if loans pile up.