One of the selling points of whole life and other permanent life insurance is that you can borrow against the cash value. Policy loans can be a useful, flexible source of money. They can also quietly erode your coverage if you’re not careful. Here’s how life insurance policy loans work, and how to use them wisely.
Quick takeaway
- Permanent policies with cash value often let you borrow against that value, without a credit check.
- Interest is charged, and unpaid loans plus interest reduce the death benefit.
- If the loan balance grows larger than the cash value, the policy can lapse, which may also create a tax bill.
- Have a repayment plan and check your loan balance at least once a year.
What a policy loan is
A policy loan is money the insurer lends you, using your policy’s cash value as collateral. Technically, you’re not withdrawing your cash value. You’re borrowing against it, and the cash value typically continues to be credited according to the policy, though some policies credit the borrowed portion differently.
Because the loan is secured by your policy, there’s usually no credit check, no approval process based on income, and no fixed repayment schedule.
Which policies allow loans
Policy loans are typically available on permanent policies that build cash value, such as:
- Whole life
- Universal life
- Indexed universal life
- Variable universal life
Term life insurance generally doesn’t have cash value, so it doesn’t offer loans. The amount you can borrow is usually limited to a portion of the cash surrender value.
How interest works
Insurers charge interest on policy loans. Depending on the policy, the rate may be:
- Fixed: a set rate stated in the contract.
- Variable: a rate that can change, often tied to a published index, within limits set by the contract.
If you don’t pay the interest, it’s usually added to the loan balance, which means you start paying interest on interest. Over years, an unpaid loan can grow faster than many people expect.
How a loan affects the death benefit
If you die with a loan outstanding, the insurer generally subtracts the loan balance and any unpaid interest from the death benefit. For example, if your policy has a $250,000 death benefit and a $40,000 loan balance, your beneficiaries might receive about $210,000. That example is hypothetical and simplified, but the principle is common across policies.
The biggest risk: lapse
If your loan balance plus interest grows larger than your cash value, the policy can lapse. Insurers typically send notices before that happens, with a chance to pay. A lapse ends your coverage. It can also create a tax problem: if the policy ends with a loan outstanding, the amount by which the loan exceeds what you paid into the policy may be treated as taxable income. Ask a tax professional about your situation.
This risk is a key reason to watch loan balances, especially on universal life and indexed universal life policies, where cash value can be affected by charges and crediting. Our guide to IUL red flags covers how heavy borrowing can strain those policies.
Dividends and policy loans
On participating whole life, a loan may affect dividends on the borrowed portion of cash value, depending on the insurer’s approach. Some insurers adjust dividends for loans, and some don’t. Ask before you borrow. Our article on whole life dividends explains more.
Good uses and risky uses
Policy loans may work well for:
- A short-term need you plan to repay, like an emergency repair
- Bridging a gap, such as between selling and buying a home
- Avoiding high-interest debt, if you have a realistic repayment plan
They can be risky when:
- You borrow large amounts with no plan to repay
- You rely on loans for long-term income without monitoring the policy
- You borrow from a policy that’s thinly funded
Smart borrowing habits
- Ask for an in-force illustration showing how the loan affects your policy over time.
- Pay at least the interest each year if you can.
- Set a repayment plan, even an informal one.
- Check your loan balance and cash value every year.
- Respond quickly to any lapse warning from your insurer.
A simple example (hypothetical)
Imagine Chris, 50, has a whole life policy with a $150,000 death benefit and $30,000 of cash value. Chris borrows $10,000 for a roof repair and pays the interest each year, then repays the loan over three years. The policy stays healthy, and the full death benefit is back in place once the loan is repaid.
Now imagine Chris borrows the same $10,000 but never pays interest or principal. Each year, the unpaid interest is added to the balance. Over time, the loan grows, the death benefit available to Chris’s family shrinks, and if the balance ever catches up with the cash value, the policy could lapse. Same loan, very different outcomes. These numbers are for illustration only.
Policy loans vs. withdrawals
Some policies, especially universal life, also allow partial withdrawals. A withdrawal permanently reduces cash value and usually the death benefit, and it may have tax consequences. A loan can be repaid. Ask which option your policy offers and how each affects coverage.
Frequently asked questions
Do I have to pay back a life insurance policy loan?
There’s usually no required repayment schedule. But unpaid loans and interest reduce the death benefit, and a large balance can cause the policy to lapse.
Is a life insurance policy loan taxable?
Generally, a policy loan isn’t taxable while the policy stays in force and isn’t a modified endowment contract. If the policy lapses or is surrendered with a loan outstanding, taxes may apply. Ask a tax professional.
How much can I borrow from my life insurance policy?
Usually up to a portion of the cash surrender value, as set by your policy. Your insurer can tell you the current maximum.
Can a policy loan cause my policy to lapse?
Yes. If the loan balance and interest exceed the cash value, the policy can lapse unless you pay. Watch your balance and respond to insurer notices.
Next step
Eric can help you review an in-force illustration and understand how a loan would affect your coverage. Learn more about life insurance with Eric Henry, Insurance Agent, or review policy types in our term vs. whole life guide.
Coverage descriptions are general information only; your policy documents determine actual coverage. Availability varies by carrier.
