Borrowing from your own policy compared with a bank loan or HELOC

A policy loan, a bank loan and a home equity line of credit (HELOC) can all put $40,000 in your account, but they differ in who approves you, what secures the money, how the interest behaves and, above all, what happens if you stop paying. A bank loan that goes unpaid damages your credit. A HELOC that goes unpaid can end in foreclosure. A policy loan that goes unpaid grows quietly until it can end the policy and create a tax bill.

None of the three is simply better. Which one fits depends on how long you need the money, how reliably you will repay it and what you are willing to put at risk. This post compares them on the points that matter, with one worked example, and says who each suits. All rates and amounts are hypothetical illustrations, since actual rates change and vary by lender and by insurer.

The three options in one paragraph each

A policy loan is a loan from your life insurer, secured by the cash value of a permanent policy. You request it by form or online, there is no credit check and no required repayment schedule, and the policy stays in force. Interest accrues at the rate in your contract and is added to the balance if unpaid. The loan reduces the death benefit by what is owed. See life insurance policy loans: how they work and what they risk.

A bank loan is usually an unsecured or lightly secured personal loan. The bank checks your credit and income, sets a fixed or variable rate and a repayment schedule, and reports the loan to the credit bureaus. If you fall behind, the consequences are late fees, collections and credit damage.

A HELOC is a revolving line of credit secured by your home. You borrow as needed up to a limit, typically at a variable rate, often paying interest only during an initial draw period and then repaying principal. If you default, the lender can pursue the home.

The comparison table

Two cells deserve a note. Interest deductibility on a home equity line has changed over the years and depends on how the funds are spent, so ask a tax professional instead of assuming. And lenders have frozen or reduced credit lines in past downturns, so a HELOC is not a guaranteed source of money when you most need it.

Approval and speed

The policy loan wins on approval. You do not have to explain what the money is for or prove your income. That is a real advantage when your credit is damaged, your income has dropped or the need is urgent.

The advantage has a cost. Because no one is checking whether you can repay, the policy is protecting you from nothing. A bank that declines you is telling you something about your finances. An insurer that says yes is only confirming that the collateral exists. People sometimes take a policy loan they should have declined, because the only gatekeeper is themselves.

Interest: what you pay and what you give up

A bank loan and a HELOC have a clear price: the interest rate. A policy loan has a stated rate and a second, less visible effect.

Insurers handle the borrowed portion of the cash value in different ways. Some credit it as if there were no loan (often called non-direct recognition). Others adjust the dividend or credit on the borrowed portion (direct recognition). In the first case, the net cost of the loan is the loan rate minus what the borrowed value keeps earning. In the second, the net cost depends on the new credit. The guide to life insurance policy loans: how they work and what they risk explains both, and the right question for any insurer is the exact method in the policy. You cannot compare a policy loan's cost without it.

A bank or a HELOC does not affect your life insurance dividends at all.

Repayment: freedom versus discipline

The policy loan has no due date. That is its best feature and its main danger. Three common patterns follow.

• Pay the interest each year. The balance stays flat, and the death benefit reduction stays fixed.
• Pay interest and some principal. The balance falls and eventually clears.
• Pay nothing. Interest is added each year and compounds.

A bank loan forces the second pattern by schedule. A HELOC forces interest during the draw period and principal later. The structure does the discipline for you. With a policy loan, you have to supply it, which is why a written repayment plan matters.

Collateral and what you stand to lose

• Policy loan: the collateral is the policy itself. The worst case is losing the coverage, plus a tax bill if the loan exceeds your basis at lapse. You do not lose your house.
• Bank loan: often no collateral. The worst case is collections and damaged credit.
• HELOC: the collateral is your home. The worst case is foreclosure.

This ranking matters for risk, but it needs one qualification. A policy that provides coverage your family relies on is also a kind of security, and losing it through a lapse is a serious harm. The risk is not "lower" in every sense. It is different in kind.

A worked example: $40,000 over five years

Say a household needs $40,000 now and expects to be repaid from a bonus in five years. The rates below are invented for illustration. The policy has a $300,000 death benefit, enough cash value to support the loan, and a 6% loan rate. The bank loan charges 9% and amortizes over 60 months. The HELOC charges 8%, interest only.

Bank loan. Monthly rate is 0.09 / 12 = 0.0075. A 60-month loan of $40,000 at that rate has a payment of about $830.33 a month. Over 60 months the household pays about $49,820, of which about $9,820 is interest. The balance is zero at the end.

HELOC, interest only. Interest is $40,000 x 0.08 = $3,200 a year, or $16,000 over five years. The $40,000 principal is still owed at the end of year five and must be repaid then. If rates rise, the payment rises.

Policy loan, repaid on the same 60-month schedule. At 6%, the monthly rate is 0.005, and the payment on $40,000 over 60 months is about $773.31. Total paid is about $46,399, of which about $6,399 is interest. The balance and the death benefit reduction fall to zero by the end. The policy loan has no required schedule, so the household chooses this plan.

Policy loan, interest only. Interest is $40,000 x 0.06 = $2,400 a year, or $12,000 over five years. The $40,000 is still owed in year five, and the death benefit is $300,000 minus $40,000, or $260,000, throughout. This is the like-for-like comparison with the interest-only HELOC, which costs $16,000 over the same five years.

Policy loan, interest never paid. The balance after five years is $40,000 x 1.06 to the fifth power. That is about $53,529, so the unpaid interest is about $13,529. If the insured died then, the benefit would be $300,000 minus $53,529, or about $246,471. After ten years the balance would be about $71,634.

Those figures lead to a few observations. With the same repayment schedule, the policy loan at 6% costs less than the bank loan at 9%: about $6,399 of interest against about $9,820. With interest only, it costs less than the HELOC at 8%: $12,000 against $16,000. The lower rate is the advantage. The policy loan becomes the most expensive path in one case, when nothing is paid and the balance compounds. The bank loan is the only one that guarantees clearance by the end of five years, because the schedule forces it. And the HELOC is the only one that exposes the home.

None of this settles which is "right." It says that the right choice depends on whether the household will really service the loan. If they will, the policy loan costs less and keeps their credit untouched. If they probably will not, the bank loan's forced schedule is protective, not just expensive.

Effects on the death benefit and the dividends

Only the policy loan touches the policy. At death, the insurer subtracts the loan and unpaid interest from the death benefit. If your family depends on that benefit, track the balance each year, because the subtraction can be large over time. Dividends, depending on the contract, may also be affected on the borrowed portion.

A bank loan or HELOC leaves the policy untouched. That matters for households that bought the coverage for a specific need, such as paying off a mortgage or supporting children. For them, preserving the full benefit may be worth a higher interest rate.

The risk that is peculiar to policy loans: lapse

If a policy loan plus interest grows to equal the cash value, the policy can lapse. The loan is then treated as an amount received, and the part above your cost basis is taxable income. A household might owe tax on money it spent years ago, with no insurance left. An overloan protection riders: how they prevent a taxable lapse can prevent this in some contracts, with its own conditions. For a policy that is a modified endowment contracts and the 7-pay test, loans can be taxable even before a lapse. See how cash value is taxed: withdrawals, loans and surrenders.

Neither a bank loan nor a HELOC has this feature. A defaulted bank loan does not make you owe income tax on the principal.

Who each option tends to suit

• A policy loan tends to suit someone with a policy that has ample cash value relative to the death benefit, a short and defined need, a disciplined repayment plan and no credit access elsewhere. It is a poor fit for someone who is already stretched or who relies on the full benefit.
• A bank loan tends to suit someone with good credit who wants a fixed schedule, a clear end date and no effect on insurance or home.
• A HELOC tends to suit someone with substantial home equity, steady income and a use for flexible access, such as staged home improvements, who is comfortable with variable rates and the home as collateral.

What to check in your own paperwork

Before comparing, collect three documents. From the insurer, get the policy's loan provision and the latest annual statement, which show the loan rate, the maximum you may borrow and any current balance. From the bank or credit union, get a written quote that states the annual percentage rate, the term and any origination fees. From the home equity lender, get the draw period, the repayment period, the index and margin that set the rate, the rate cap, and the conditions under which the lender may freeze or reduce the line.

Then put the same borrowed amount and the same time horizon into each. Differences in fees matter more than people expect on small loans, and a rate quoted for the first year may not be the rate for the rest. A loan with a lower stated rate can cost more once fees and a rate reset are included, so total the dollars rather than comparing percentages alone.

Finally, think about what else you could do. If the need is a one-time purchase, saving for it or choosing a smaller one may beat all three. If the need is an emergency, the order of options in using cash value in a financial emergency: the order to try things shows where a policy loan sits among the choices that cost less and the ones that cost more.

Questions to settle before borrowing

1. How long will I need the money, and when exactly will I repay it?
2. What is the total interest in dollars under each option?
3. What is the worst thing that happens under each if I miss payments?
4. How would the loan change my death benefit and my family's protection?
5. Can I put the repayment plan in writing and set a reminder?
6. Have I asked the insurer the loan rate, the recognition method and the lapse warnings?

The policy loan calculator can model the policy loan balance under different repayment plans. For the whole picture, including taxes, a fee-only planner can compare the three paths.

Key takeaways

• A policy loan has no approval step and no due date, while a bank loan has a schedule and a HELOC puts your home at stake.
• Only the policy loan reduces the death benefit, and only it can lapse your coverage and create a tax bill.
• In the worked example, a $40,000 policy loan repaid over 60 months costs about $6,399 in interest against about $9,820 for a bank loan at a higher rate, but an unpaid policy loan grows to about $53,529 in five years.
• The right choice depends mainly on whether you will actually repay; forced schedules protect people who might not.
• Ask the insurer for the loan rate, recognition method and lapse notices before you borrow.