A policy loan is money you borrow from the life insurance carrier, with the policy’s cash value as collateral. There is no credit check. The carrier charges interest. You can choose not to repay on a schedule, and unpaid interest is added to the loan. The death benefit is reduced by the outstanding loan. If the loan and interest grow larger than the cash value, the policy can lapse. A lapse with a loan outstanding can create a taxable gain even though you received no new cash that year.
Term life has no cash value. There is nothing to borrow.
How the loan works
You request an amount up to a percentage of the cash value, often around 90 percent, so a buffer remains for interest. The cash value stays in the policy and continues to earn whatever the contract credits, which may be a lower rate on the borrowed portion. You pay interest to the carrier. Some contracts credit a rate close to the loan rate, so the net cost is small. Others do not. The spread is the real price of the loan.
Repayment is flexible. That flexibility is how loans get large. Interest you do not pay is capitalized. A loan that started as a small withdrawal of cash can, years later, threaten the policy.
Tax and lapse
Loan proceeds are generally not taxable when you receive them, because they are a loan. If the policy lapses or you surrender it while a loan is outstanding, the loan is treated as part of the amount you received. The taxable gain can be larger than the cash you have in hand. People get a tax bill on a policy that collapsed.
A policy that becomes a modified endowment contract changes the tax order of loans and withdrawals. Loans from a MEC can be taxable. Know whether the policy is a MEC before you borrow.
Loan versus withdrawal
A partial surrender removes cash value and usually reduces the death benefit permanently. A loan keeps the value in the contract and charges interest. Use the one the policy allows. On whole life, loans are the normal way to access cash. On universal life, both may exist, and a withdrawal can also change the death benefit option math.
How cash value supports a loan is on the whole life cash value page.
Borrow only against a policy that can carry the loan
See the loan rate, the rate credited on borrowed funds, and an in-force illustration with the loan left unpaid. If the illustration lapses, the loan is too big or the premium is too small.
Conclusion
We illustrate the loan unpaid before anyone takes it. The interest, the reduced death benefit, and the lapse risk are the product, not a side note. Across 30+ A-rated carriers, loan rates and the credit on borrowed value are not the same, and that spread is what the cash actually costs.
Our agents will also say when the policy is the wrong place to borrow because the cash value cannot support the interest.
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