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Life Insurance Policy Loans: How They Work and Risks

Policyholder reviews life insurance loan papers

A life insurance policy loan lets you borrow from the insurance company, using the cash value of a permanent policy as collateral. Whole life and universal life policies can do this. Term life cannot, because it builds no cash value. There is no credit check, and the loan is generally not taxable income while the policy stays in force. The catch is that unpaid loans and interest shrink your death benefit and can eventually lapse the policy. Below is how to borrow, what it costs, and how to do it safely.

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TL;DR

  • You can borrow against whole life and universal life policies once they have enough cash value. Term life has none.
  • Most policies let you borrow up to about 90% of cash value, with no credit check and no set repayment schedule.
  • Loan interest is commonly in the mid-single digits, and older policies can carry higher fixed rates.
  • An unpaid balance reduces the death benefit. If the loan outgrows the cash value, the policy can lapse and trigger a tax bill.
  • A loan keeps your cash value in the policy. A withdrawal permanently removes it.

Table of Contents

How cash value works

Cash value is the savings side of a permanent policy. When you pay a premium, one portion goes to the death benefit, another covers the insurer’s costs and profit, and the rest goes to cash value. Whole life, universal life and variable life can build it. Term life doesn’t.

It starts slowly. In most cases cash value doesn’t grow meaningfully for the first two to five years. Your full death benefit is still payable from day one, as the South Carolina Department of Insurance explains. That is why a brand-new policy usually has little or nothing to borrow against.

The three cash value types behave differently:

If you want to see how whole life fits a plan, our whole life insurance page is a good starting point.

Cash value vs. death benefit

These are two different numbers on the same policy, and they pay out in different situations. The New York Department of Financial Services puts it plainly: if you die, your beneficiaries receive the face amount; if you surrender the policy, you receive the cash value instead. The face amount is higher than the cash value, especially in the early years.

One point surprises people. Taking cash value out reduces the future death benefit for your heirs, and unused cash value is generally forfeited to the insurer at death. Your family does not receive the death benefit plus the cash value. They receive the death benefit, less any loan.

How a life insurance policy loan works

When you take a policy loan, the insurer lends you its own money. Your cash value is the collateral, and it stays in the policy. In New York’s guidance, the owner may generally borrow if there is enough cash value to secure the loan, and some policies impose a waiting period of up to three years.

The practical features:

  • No application or credit check. Policy loans don’t require a credit check or an approval process.
  • Borrowing limit. Most cash-value policies allow up to 90% or more of the cash surrender value, often with funds arriving within about a day.
  • Flexible repayment. There is generally no required schedule. You can repay on your own timeline, pay only the interest, or leave the loan outstanding.
  • You must own the policy. Only the policy owner can borrow, so check who is named as owner on your contract.

How to borrow, step by step

  1. Check your latest annual statement for current cash value, any existing loans and the loan interest rate.
  2. Confirm the loan provisions in your policy, including any waiting period and whether the rate is fixed or variable.
  3. Request a loan form from your insurer, usually online or by phone, and state the amount.
  4. Choose a repayment plan before the money arrives: interest only, regular principal and interest, or a lump sum later.
  5. Mark your calendar to review the balance against cash value every year.

What a policy loan costs

Interest varies by company and policy. Some policies have a fixed rate written into the contract, others a variable one. The Wall Street Journal reports many whole life policies currently sit in the 5.7% range, while some older policies carry fixed rates as high as 8%. Interest is charged at the rate specified or described in your policy, so the contract is the final word.

A simple example shows the stakes. Suppose your policy has $50,000 of cash value and you borrow $40,000 at 6%. Interest of about $2,400 accrues in the first year. If you don’t pay it, it is added to the balance, and the next year’s interest is charged on a bigger number. Over time an unpaid loan can climb toward the cash value, which is the point where trouble starts.

Policy loan balance grows with unpaid interest

Because the loan is not a loan from a bank, the rate is set by your insurer and not by your credit score. That is helpful for someone with limited credit options. It also means you should compare the rate with other ways of borrowing before you choose.

Loan vs. withdrawal

A withdrawal and a loan both turn cash value into money, but they work differently.

Policy loan Withdrawal
What happens to cash value Stays in the policy as collateral Permanently removed
Death benefit Reduced only while the loan is outstanding Permanently reduced
Repayment Optional, on your schedule Cannot be put back
Interest Charged on the loan None

This comparison follows an advisor’s breakdown of loans and withdrawals, which notes that a loan reduces the death benefit only while it is outstanding and that repayment restores it. Typical loan interest of 4 to 6% is cited there as well. Your own contract sets the actual terms.

If you want the policy to stay intact for your family, a loan that you actively manage is usually the route to talk through first.

Taxes on policy loans

In general, a policy loan is not income. It is the receipt of a personal loan, so it is not taxable when received. Investopedia adds that the IRS doesn’t count the loan as income while the policy stays active, provided it is not a modified endowment contract.

Two situations change that:

  • Modified endowment contracts (MECs). A policy that is funded faster than IRS limits allow becomes a MEC. Loans from a MEC are taxed differently and can carry a penalty if taken before age 59½. Ask your insurer whether your policy is a MEC before you borrow.
  • Lapse or surrender with a loan outstanding. This is the one that catches people. When a policy ends, relief from the loan is treated like a cash distribution and is taxable to the extent it exceeds your basis. Basis is generally the premiums you paid, reduced by prior principal distributions.

A recent Tax Court case shows the scale. In Sawyer v. Commissioner, a policy with about $205,433 of cash surrender value and a basis of about $44,533 produced roughly $160,900 of taxable gain after it terminated, even though no money was paid out to the owner at that point. That is sometimes called phantom income: a tax bill on money you never received.

If you have a large loan against a policy, talk to a tax professional before you surrender or stop paying premiums.

Taxes on policy loans

What happens if you don’t repay

Nothing forces you to repay a policy loan. But the balance does not sit still.

The risk grows when a policy has been in force for many years with a lot of gain inside it, or when premiums are being paid through automatic premium loans. Attorneys at one estate-planning firm note the same risk is higher when the owner no longer monitors annual policy statements.

A few habits keep a loan safe:

  • Pay at least the annual interest so the balance doesn’t grow.
  • Read each annual statement and compare the loan balance to cash value.
  • Ask your insurer for an in-force illustration if the gap is narrowing.
  • Keep your beneficiary information current, which our guide to beneficiary mistakes covers.

Perspective

Most people who call us about borrowing from a policy aren’t in a crisis. They are retirees who remember buying a whole life policy decades ago and want to know what it can do for them now.

Our approach is education first. Before anyone takes a loan, we want them to know three numbers: the current cash value, the loan rate, and the point at which the balance would put the policy at risk. Once those are clear, the decision is usually straightforward.

We also look at the whole picture. A policy that was bought to cover final expenses or leave something to family should still do that job after a loan. Sometimes the best answer is a modest loan with the interest paid yearly. Sometimes it is a different tool altogether, and we say so.

That is the benefit of working with a local agent in Central Oregon: no call center script, no pressure, and a conversation at your own pace.

Jesse Zimmerman

Who should and shouldn’t expect a loan option

Not every policy qualifies, and not every person holds the kind of policy they think they do.

  • Term life: no cash value, so no loan. If you hold term coverage nearing its end, our term life conversion guide explains how converting to permanent coverage works.
  • Final expense and burial policies: these are small whole life policies. Cash value tends to be modest, so any loan is small. See our overview of final expense insurance.
  • Guaranteed issue policies: these often have waiting periods before full benefits apply, which is covered in our guaranteed issue waiting period guide.
  • Newer permanent policies: with only a couple of years of premiums paid, cash value may be too low to borrow against.

If you are unsure what your policy is, find the policy number and the insurer’s phone number on your statement. The policy type and current cash value are listed on the annual report.

Talk it through with a local agent

If you live in Central Oregon and want a second pair of eyes on a policy, we offer free educational consultations in person or remotely. We help with term, whole life and final expense coverage, and we can walk through how a loan would fit with your retirement and Medicare planning. Start at Mountaintop Insurance and tell us what you hold.

FAQ

Can I borrow against term life insurance?

No. Term life has no cash value, so there is nothing to use as collateral. Only permanent policies such as whole life and universal life can be borrowed against.

How soon can I borrow against a whole life policy?

It depends on the policy. Cash value usually takes two to five years to grow meaningfully, and some policies add a waiting period of up to three years. Check your contract or ask your insurer.

Do I have to pay back a life insurance loan?

There is generally no required schedule. But unpaid interest is added to the balance, and any amount owed reduces the death benefit your beneficiaries receive. If the balance exceeds the cash value, the policy can lapse.

Is a life insurance loan taxable?

Generally not while the policy stays in force and is not a MEC. A lapse or surrender with a loan outstanding can create taxable income to the extent the amount exceeds your basis, so involve a tax professional before ending a policy with a loan.

What’s the difference between a loan and a withdrawal?

A loan uses cash value as collateral and leaves it in the policy. A withdrawal permanently takes cash value out and permanently reduces the death benefit.

Sources

Disclaimer: This article is for general educational purposes only and does not constitute personalized advice. Medicare rules and plan details change frequently.

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