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Fixed, variable and wash loans compared: what borrowing costs net
Policy loan rate structures side by side on a hypothetical $40,000 balance: net cost after credited interest, predictability and the questions that expose it.
A life insurance policy loan has two prices, and only one of them is printed on the loan form. The printed one is the loan interest rate. The other is what your borrowed cash value stops earning, or keeps earning, while it is pledged. The difference between the two is the net cost of the loan. Fixed, variable and wash loans are three ways of setting that difference, and comparing them by the headline rate alone is the most common error in this part of the market.
The idea behind net cost
When you borrow, the insurer pays you its own money and keeps your cash value as collateral. Your cash value does not leave the policy. But the insurer may credit the loaned part of it at a different rate than it credits the rest, or may adjust the dividend on it (see direct and non-direct recognition loans: how borrowing affects dividends for the dividend side). So the real question is:
Net cost of the loan = loan interest rate - rate credited on the loaned cash value
If a policy charges 5% on the loan and credits 3% on the borrowed portion, the net cost is 2 percentage points. If it charges 4% and credits 4%, the net cost is zero. If it charges 6% and credits nothing on the borrowed portion, the net cost is the full 6%.
The terms policy loan interest, crediting rate and policy loan are defined in the glossary. The rest of this post uses them in that sense and applies them to three structures.
The three structures in one table
All descriptions are the common patterns. Contract wording varies, so treat the table as a map of questions, not a description of any company.
| Feature | Fixed-rate loan | Variable-rate loan | Wash (or preferred) loan |
|---|---|---|---|
| How the loan rate is set | A stated rate for as long as the loan is outstanding | Moves with a published index or with the insurer's declared rate, within a stated maximum | Set equal to, or close to, the rate credited on the loaned value |
| Rate on the loaned cash value | Usually a declared or guaranteed rate that may differ from the loan rate | Often a declared rate that may not move in step with the loan rate | The same as the loan rate, or within a small spread |
| Net cost | The spread, steady if both rates stay put | The spread, which can widen or narrow | Near zero, sometimes with a small fee |
| Predictability | High on the loan side, less on the credited side | Lower: both sides can move | High if the contract guarantees the match |
| Where you find it | Many whole life and universal life contracts | Many universal life and some whole life contracts | Some universal life and some whole life contracts, often with conditions |
| What to verify | Is the credited rate guaranteed or declared? | The maximum rate and how often it can change | When it starts, how much can be borrowed this way, and whether it is guaranteed |
A fourth pattern deserves a mention. In indexed universal life, the loaned cash value may be credited by an index strategy instead of a fixed rate, or may be moved to a fixed account. That makes the credit uncertain from year to year. It is covered below because it behaves differently from the other three.
Fixed-rate loans
A fixed-rate loan is the easiest to understand. The contract states a rate, say 5%, and that is the rate on this loan. You can compute next year's interest without guessing: balance x rate.
What a fixed loan rate does not tell you is what the insurer will credit on the borrowed portion. If the credit is a declared rate that the company can lower, the net cost rises when the company lowers it, even though your loan rate never moves. If the credit is guaranteed, say a stated minimum, the worst case is bounded and the net cost has a known ceiling.
What it suits. A borrower who values knowing the cost of the debt, expects to keep the loan a long time, and has read the credit terms. What it risks. A fixed rate set when market rates were high can look expensive for years if rates fall. A fixed rate set when rates were low favors the borrower, and some contracts instead state only a maximum rate that the insurer may charge.
Variable-rate loans
A variable loan rate moves. It may be reset each year to a published index, such as a corporate bond yield average, plus or minus a stated margin, or to a rate the insurer declares. Contracts usually set a maximum, and some set a minimum.
The appeal is that a variable rate can track the market: when rates fall, the cost of borrowing falls with them. The risk is the other side of the same idea. Rates can rise, and the loan cost rises with them. If the credit on the loaned cash value is a declared rate that moves slowly or not at all, the spread widens exactly when you can least afford it.
What it suits. A borrower who plans to repay quickly, or who is comfortable with rate risk and has read the maximum. What it risks. Long-term unpaid loans, where compounding at a rising rate is painful.
Wash loans
A wash loan, sometimes called a preferred loan or a zero-net-cost loan, is built so that the interest the insurer charges is offset by the interest it credits on the loaned cash value. If both are 4%, you pay $1,600 a year on a $40,000 loan, and the borrowed portion earns $1,600. The net cost is zero.
This looks almost too good, and the conditions are where it needs reading:
- When it begins. Some contracts offer wash treatment only after a number of policy years, or only for the portion of cash value above total premiums paid, which is the policy's gain.
- How much qualifies. A limit may apply, so a loan larger than the qualifying amount is partly wash and partly standard.
- Is the match guaranteed? Some contracts guarantee a net spread, some state a maximum net charge, some only describe the current practice. Current practice is a non-guaranteed element and can change.
- Is there a fee? A small annual charge may remain.
- What does the policy credit overall? A wash loan makes borrowing cheap relative to the credited rate, but if the credited rate is itself low, you are borrowing at a low rate that is also a low return.
What it suits. A borrower who expects to use the loan feature heavily and has a contract that states the terms. What it risks. Treating it as free money. The tax rules on lapse still apply (see how cash value is taxed: withdrawals, loans and surrenders), and a loan, even a cheap one, still reduces the death benefit.
Indexed loans in indexed universal life
In an indexed universal life policy, the loaned cash value may be moved out of the index strategies or may remain in them, and the contract determines what it earns. Some contracts credit the loaned portion by the same index formula, which means a year with no index gain leaves the borrower paying the full loan rate with nothing credited on the loaned value. Others credit a fixed rate. A third group offers an alternative where the loan rate floats with the credited rate.
Invented example: a $40,000 loan at 5% on loaned value credited by an index strategy. Over four years the index credits are 0%, 8%, 0% and 6%.
| Year | Loan rate | Credit on loaned value | Net cost (percentage points) | Net cost on $40,000 |
|---|---|---|---|---|
| 1 | 5% | 0% | 5 | $2,000 |
| 2 | 5% | 8% | -3 | -$1,200 (a net gain) |
| 3 | 5% | 0% | 5 | $2,000 |
| 4 | 5% | 6% | -1 | -$400 (a net gain) |
| Total | 6 | $2,400 |
The four-year total is $2,400, which averages $600 a year, or 1.5 points. Had the credit been a steady 3%, the net cost would have been 2 points a year, $800 a year, $3,200 in four years. So this path looks cheaper than the steady credit. A weaker path, say credits of 0%, 0%, 0% and 6%, would give 5 + 5 + 5 - 1 = 14 points, which is $5,600 over four years. That is the point of the example: an indexed credit can produce either result, and a long run of zero years is a real possibility. The guide on Indexed universal life (IUL) explained explains the crediting methods, and Indexed UL loan mistakes: rate, crediting and lapse traps covers the traps.
A ten-year comparison with invented numbers
Say a borrower takes a $40,000 loan and the borrowed cash value is credited a steady 3% in the first two structures. These are illustrations, not prices.
Case 1, fixed loan at 5%, credit 3%. Net cost is 2 points, or $800 a year if the borrower pays the loan interest each year. Over ten years, $8,000.
Case 2, variable loan, same 3% credit. Say the loan rate follows this path over ten years: 5.0%, 5.5%, 6.5%, 7.5%, 7.0%, 6.0%, 5.5%, 5.0%, 4.5%, 4.5%. Subtract the 3% credit: 2.0, 2.5, 3.5, 4.5, 4.0, 3.0, 2.5, 2.0, 1.5, 1.5 points, which add up to 27 points. On $40,000 that is 27% of $40,000 = $10,800 over ten years.
Case 3, wash loan at 4% credited at 4%. Net cost is zero, so $0 over ten years, ignoring any fee.
Now suppose the borrower pays none of the interest, so it compounds. After ten years:
| Case | Loan balance after 10 years | Value of the loaned $40,000 credited at 3% (or 4% in Case 3) | Gap |
|---|---|---|---|
| 1 Fixed 5% | $65,155.79 | $53,756.65 | $11,399.14 |
| 2 Variable path above | $69,602.33 | $53,756.65 | $15,845.68 |
| 3 Wash 4%/4% | $59,209.77 | $59,209.77 | $0 |
The arithmetic: $40,000 x 1.05 to the tenth power is $65,155.79; the variable path multiplies the balance by (1 + rate) each year in turn; $40,000 x 1.03 to the tenth power is $53,756.65; and $40,000 x 1.04 to the tenth power is $59,209.77. The gap column is the compounding cost of the unpaid loan, over and above what the loaned value earned. Notice that the wash case still leaves a loan of $59,209.77 against the same amount of loaned value. The loan does not shrink, so the death benefit is still reduced by it. Wash makes the loan cheap, not harmless. To run your own version, use the policy loan calculator or the method in policy loan worksheet: interest, repayments and what the policy can carry.
The questions that reveal the real cost
Pose these to the insurer or the agent, and ask for answers in writing:
- What is the loan interest rate today, is it fixed or variable, and what is the maximum?
- What rate is credited to the loaned portion of the cash value, and is it guaranteed, declared, or index-linked?
- What was the net spread (loan rate minus credited rate) last year, and what is the worst case in the contract?
- Does the policy offer wash or preferred loans? When do they begin, how much qualifies, and are the terms guaranteed?
- Are there loan fees, and is interest charged in advance or in arrears?
- If I pay no interest, how is the unpaid interest added to the loan, and when?
- How does the in-force illustration treat loans, and are the assumptions current or lower? See how to request and read an in-force illustration.
The answer to question 3 is the one most likely to be missing. A company that cannot state the spread is giving you only half the price.
Where the loan rate sits among a policy's other costs
A loan structure is one input to a policy's long-run health, not the whole picture. Two other items interact with it.
Premiums and charges. In a universal life policy, monthly charges for the cost of insurance and expenses come out of the cash value. If you borrow and also stop paying premiums, the account is paying its own charges while the loan grows alongside. A cheap loan does not slow that. The guide on current-assumption universal life and crediting rates explains how those charges and the credited rate interact, and why a projection that looked fine at purchase can change.
The guaranteed floor. Many contracts state a guaranteed minimum credited rate. If the net cost of a loan is measured against a declared rate that sits well above the guaranteed one, the worst case is worse than the current case. When you compare two policies, compare the guaranteed spread as well as the current spread, because the current spread is a non-guaranteed element and the company can change it.
A practical habit follows: when you read an illustration that shows loans, ask which column the loan is using, guaranteed or current. If the loan only works in the current column, the plan depends on the insurer keeping its present practice.
Who each structure tends to suit
- Short-term, repay-soon borrowers can accept a variable rate, because compounding has little time to hurt. The main risk is a sudden rate spike, and a maximum limits it.
- Long-term borrowers who want certainty tend to prefer a fixed loan rate with a guaranteed credit, or a wash loan with a guaranteed match.
- Borrowers using a policy mainly for its death benefit should weigh a low-cost wash feature less than the strength of the policy's guarantees. A policy that is cheap to borrow from but weak at holding its death benefit is a poor trade.
- Anyone considering a bank loan or home equity line instead can compare the net cost of the policy loan with the bank's rate. Borrowing from your own policy compared with a bank loan or HELOC does that comparison.
Key takeaways
- The net cost of a policy loan is the loan rate minus the rate credited on the loaned cash value, not the loan rate alone.
- A fixed loan rate gives certainty on one side only; check whether the credit on the loaned portion is guaranteed.
- A variable rate can follow the market down or up; look for the maximum, and favor quick repayment.
- A wash loan makes the net cost near zero, but check when it starts, how much qualifies and whether it is guaranteed.
- In the invented $40,000 example, ten years of net cost came to $8,000, $10,800 or $0 depending on structure, and the wash loan still left a $59,209.77 balance against the death benefit.