Life insurance policy loans: how they work and what they risk

A life insurance policy loan lets you borrow from the insurer using your policy's cash value as collateral. There is no credit check and no required repayment schedule, and a loan from a policy that is not a modified endowment contract is generally not taxed as income while the policy stays in force. The costs are interest that keeps compounding, a smaller death benefit while the loan is unpaid, and a real risk that the policy lapses and triggers a tax bill if the balance outgrows the cash value.

How a policy loan works

Only permanent policies build cash value: whole life, universal life, indexed universal life and variable universal life. Term insurance has nothing to borrow against. Your contract states how much you may borrow, often a high percentage of the cash surrender value and sometimes close to all of it. See whole life cash value: how it grows and how to use it for how that value builds.

The insurer lends you its own money and holds your cash value as security. You are not withdrawing your savings, so the policy stays in force and the death benefit stays in place, reduced by whatever is owed. That is the main difference from a withdrawal (see withdrawing cash value from a life insurance policy).

You request the loan by form or online. Money usually arrives within days. Repayment is up to you: you can pay principal, pay only the interest, or pay nothing.

What it costs: the interest

The loan interest rate is written in the contract. It may be fixed, or variable and tied to a published index, and some contracts guarantee a maximum. Interest is charged annually or at each policy anniversary. If you do not pay it, the insurer adds it to the loan balance, and from then on you pay interest on the interest.

What matters is the spread between what you pay and what your cash value earns while it is borrowed against. Insurers handle the borrowed portion in different ways:

• Direct recognition. The insurer changes the dividend or credited interest on the borrowed portion, which can raise or lower your results depending on the rates.
• Non-direct recognition. Dividends or credits are set as if there were no loan, so you owe loan interest while the cash value keeps earning the full rate.
• Fixed-rate versus variable-rate loans, and "wash" or preferred loans in some universal life policies, where the net cost of the loan is close to zero.

Ask for the exact loan provisions in writing, and compare them with the how to request and read an in-force illustration for your policy. The policy loan calculator shows how a loan balance grows under different interest and repayment assumptions.

Hypothetical example: a loan left unpaid

Say a policy owner has a $250,000 death benefit, $60,000 of cash value, and has paid $40,000 in premiums (the cost basis). The owner borrows $30,000 at 6% interest and never pays the interest, so it compounds. These numbers are invented to show the mechanics.

If the cash value had grown to only $90,000 by year 20, the $96,200 loan would exceed it. The policy would lapse. Under that outcome the owner would owe income tax on the loan amount above basis (about $56,200 in this example), with no cash received at the time of the lapse and no insurance left. That is the central danger of policy loans.

Tax treatment

The details are in how cash value is taxed: withdrawals, loans and surrenders; the short version, based on the Internal Revenue Code and IRS guidance:

• Policy not a MEC. Loans are treated as debt, not income. Interest you pay on a personal-use loan is not deductible.
• Modified endowment contract. If the policy was funded too fast and fails the seven-pay test, it is a modified endowment contracts and the 7-pay test. Loans are then taxed as income to the extent of gain in the policy, gain first, and a 10% additional tax generally applies to the taxable amount before age 59½.
• Lapse or surrender with a loan outstanding. The unpaid loan counts as an amount received. The part above your basis is taxable as ordinary income, even though you received no new cash. See surrendering a life insurance policy: what you get and what it costs.
• At death. The insurer subtracts the loan and unpaid interest from the death benefit, and the remainder is generally income-tax-free to the beneficiary. See is life insurance taxable?.

Tax facts depend on your situation; a tax professional can confirm how they apply to your policy.

When a loan makes sense, and when it does not

It can fit when you need short-term cash and expect to repay, when you want to bridge a gap without a credit check, or when you will keep the policy until death and accept a reduced benefit.

It is a poor fit when the policy is already stretched (little cash value relative to the death benefit), when the loan rate is well above what the cash value earns, when you do not plan to pay interest, or when the policy is a heavily loaded universal life contract where cost-of-insurance charges rise with age. Financial planners also debate using loans as a retirement income stream; the case for and against is covered in how cash value is taxed: withdrawals, loans and surrenders and the guides on cash value strategies.

Protecting a policy with a loan

1. Ask for an annual loan statement showing balance, interest rate, cash value and projected lapse date.
2. Pay at least the interest each year if you can, so the balance does not compound.
3. Run an in-force illustration at your current loan level every few years. Ask the insurer to project it to age 100.
4. Check for protection features. An overloan protection riders: how they prevent a taxable lapse can keep a policy from lapsing when loans get very large, and an automatic premium loans provision can use loans to pay premiums. Both change the math and some carry a charge or tax consequences.
5. If the loan is nearing the cash value, repay, add premium, or reduce coverage before the policy lapses. Weigh the alternatives with the keep, surrender or sell your policy?.

A reinstatement is possible after a lapse, but it may require evidence of insurability and repayment of back amounts; taxes triggered by the lapse may not be reversible.

Key takeaways

• A policy loan uses your cash value as collateral, needs no credit check, and has no mandatory repayment schedule.
• Unpaid interest compounds, and the loan balance reduces the death benefit dollar for dollar.
• Loans from a non-MEC policy are generally not taxed while the policy stays in force; loans from a MEC and loans outstanding at lapse or surrender can be.
• A loan larger than the cash value can lapse the policy and create a tax bill with no cash to pay it.
• Check the loan rate, the way dividends or credits change on borrowed value, and a projected lapse date before borrowing.