What happens to a life insurance policy when the policy loan balance exceeds the cash value

Policy Loan Explained

Updated November 18, 2021

Permanent life insurance offers living benefits as well as a death benefit. The death benefit is how much policy beneficiaries are paid when the insured person dies. Living benefits are generally cash amounts the policy owner can access while still alive. 

Arguably one of the most valuable living benefits is the ability to access the equity in your policy—the cash value—by taking out a policy loan. A policy loan is money you borrow from the insurance carrier, with your policy’s cash value and death benefit serving as collateral. If you default on the policy loan, your insurer will settle the outstanding loan amount from your death benefit before paying your beneficiaries.

This article will explain what a policy loan is, how it works, and what pros and cons you should consider before borrowing from your life insurance policy.  

Definition of a Policy Loan

If you carry a permanent life insurance policy, it's possible to take out a loan using the cash value in your policy as collateral—hence the name “policy loan.”

You can only take out policy loans from permanent life insurance, which is available as either universal life or whole life. 

How a Policy Loan Works

Some insurance providers make policy loans available as soon as your policy has a cash surrender value. In contrast, other insurance companies require that you hold the policy for a certain number of years before taking a policy loan (and the policy must also have a cash surrender value). 

The size of the loan you can take out from your life insurance policy is generally equal to the cash surrender value. However, your insurance company may retain a portion of that value in order to pay the year’s policy premiums and interest on the loan. For example, military policyholders who hold qualifying permanent insurance policies may borrow as much as 94% of their policy’s cash value after it has been active for one year, or they may surrender the policy for its cash value.

One unique feature of policy loans is that the insurance company will not check your credit before issuing the loan. (After all, since the insurer holds the keys to your cash value, it knows you’re “good for it.”) But like any other loan, your policy loan will accrue interest. Some insurers charge a fixed rate, and others use a variable interest rate. This should be spelled out in your policy documents.

Another important feature is that policy loans have a flexible repayment timeline. You can pay whenever works for you, as opposed to the monthly payments you might be required to make on another type of loan. But there's a catch: Interest continues to accrue whether you make payments or not, thus increasing the loan balance—and if you don’t make payments, you’ll pay interest on a larger amount. If your loan balance increases such that it equals or exceeds the cash value, your life insurance policy is at risk of lapsing. 

If your life insurance policy lapses, it means you lose the policy, the cash value, and the death benefit. You also face taxation on any amount that was in the cash value over the amount you paid into the policy (premiums). Put simply, the tax implications can be dire. 

Pros and Cons of a Policy Loan

Pros

• Lower interest rates

• Greater flexibility

• Quick cash with minimal paperwork

Cons

• Unpaid loans and accrued interest will reduce your death benefit

• Possible tax implications

Pros Explained

• Lower interest rates: When compared to other borrowing options, such as personal loans or credit cards, policy loans typically have lower interest rates. The maximum fixed interest rate shouldn’t exceed 8% per annum. 
• Greater flexibility: Life insurance policy loans offer greater flexibility in repaying your loan. You pay back the loan on your schedule, not your bank’s or credit card issuer’s schedule. While you can skip payments as necessary, you should pay at least the interest on a regular basis to prevent the loan balance from increasing. 
• Quick cash with minimal paperwork: Policy loans let you access money against your cash surrender value without the need to go through a lengthy application process. Your insurance company won't run any form of credit check, and you won’t be set back by a lengthy waiting period. 

Cons Explained

• Unpaid loans and accrued interest will reduce your death benefit: Sure, policy loans come with lower interest rates, but that interest could undercut your death benefit if you don’t make payments on the loan. Plus, the flexible payment schedule could easily hoodwink you into skipping payments. The more interest you accrue, the more it could reduce your death benefit. 
• Possible tax implications: The question of whether or not to pay back your life insurance policy loan is not one to make lightly. If your loan balance nears your cash value—which you pledged as collateral for the loan—your insurance provider will use the cash value to pay off the loan. This may cause your policy to terminate and result in serious income tax ramifications. Strive to pay back at least the annual interest.

Is a Policy Loan Worth It?

If you have permanent life insurance, a policy loan can be a great resource for easy and quick access to cash. But it's wise to consider all financing options before taking out a policy loan. Though you'll enjoy the benefits of a flexible payment schedule and lower interest rates than many personal loans, remember why you got the life insurance policy in the first place: to financially protect your dependents in the event of your untimely death. If it’s essential to keep the death benefit intact, such as to cover the costs of the mortgage on your family home, you may want to shy away from this type of loan.

Policy loans won’t suit every situation and can create substantial tax consequences if they cause the policy to lapse.

That said, a policy loan can be ideal when you have a short-term need and are confident in your ability to pay back the funds in a timely manner. 

Key Takeaways

• A policy loan is the money you can borrow from your life insurance company, using your policy’s cash value as collateral.
• Policy loans have no fixed repayment schedule, but you’ll need to repay your insurer with interest. 
• If interest accumulates such that the loan balance is equal to or exceeds your policy’s cash value, the policy will lapse, the cash value will be used to pay off the loan, and you’ll be liable for taxes on the cash value amount that exceeded your premium payments.
• If you pass away with an outstanding policy loan, the loan balance plus any interest owed will reduce the death benefit paid to your beneficiaries.
• A policy loan is a good option if you have a short-term need and have a concrete plan to repay the loan. 

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