What it means
Certain life insurance policies, such as whole life and universal life, build up a cash value over time: a savings-like balance inside the policy that belongs to the policyholder. A policy loan lets that value be borrowed against without cancelling the cover, which is why it is sometimes described as borrowing from yourself.
Strictly speaking you are not borrowing your own money. The insurer lends its own funds and holds the policy's cash value as security, which is why interest is charged and why the loan reduces what the policy will eventually pay.
The commercial appeal is speed and flexibility. There is no credit check, no stated purpose and usually no fixed repayment schedule, so business owners have used policy loans to bridge a payroll gap or fund a deposit when a bank facility would take weeks.
The catch is that unpaid interest is added to the loan balance and then charges interest itself. Over a long period that compounding can quietly grow the debt towards the cash value, and if the balance exceeds the cash value the policy can lapse, which may trigger an unpleasant tax bill on gains that were never actually received in cash.
Rates and mechanics vary by contract. Some policies charge a fixed rate, others a variable one, and some continue to credit dividends on the full cash value while a loan is outstanding, which materially reduces the true net cost of borrowing.
There is also a difference between a loan and a withdrawal, and the two are easy to muddle. A withdrawal permanently removes cash value and usually reduces the death benefit straight away, while a loan leaves the cash value in place as security and can be repaid to restore the full payout.
In practice
Real-world examples.
Example
A dental practice owner needs $40,000 quickly to replace a failed X-ray unit. Rather than wait three weeks for equipment finance, she takes a policy loan against her whole life policy and repays it over the following eight months.
Example
A retired couple use a policy loan to cover a large roof repair, preferring it to selling shares in a down market. They accept that the outstanding balance will reduce the amount their children eventually inherit.
Example
A small manufacturer takes repeated policy loans over a decade without repaying them. The accrued interest eventually consumes most of the cash value and the policy is at risk of lapsing, forcing an unplanned lump sum repayment.
Think of it
“Policy loan is borrowing from your insurance-using cash value as collateral.
Formula
Calculation
Loan balance after n years with no repayments = principal x (1 + interest rate) to the power of n. Net death benefit = death benefit - (loan principal + accrued interest).
Take a whole life policy with a $500,000 death benefit and $180,000 of accumulated cash value. The policyholder borrows $50,000 at 6% interest, compounded annually, and makes no repayments for three years. The balance grows to $50,000 x 1.06 x 1.06 x 1.06 = $50,000 x 1.191016 = $59,550.80. If the policyholder dies at that point, the beneficiaries receive $500,000 - $59,550.80 = $440,449.20. The loan has therefore cost the family $9,550.80 in accrued interest on top of the $50,000 originally taken out.Case study
Seen in the real world.
Harrow Lane Joinery is an invented company used for this illustrative example. Its founder held a whole life policy with $210,000 of cash value when a major customer stretched its payment terms from 30 days to 90, leaving the workshop $60,000 short on payroll.
Rather than take an expensive short-term loan, the founder borrowed $60,000 against the policy at 5% and repaid it in four instalments across the year as the receivable came in. The total interest cost in this fictional scenario was well under what an unsecured facility would have charged, and the cover stayed fully in force throughout.
The lesson the illustrative business drew was about discipline rather than cleverness. The founder set a formal repayment schedule for herself, because the very feature that makes policy loans attractive, the absence of a required repayment date, is also what lets balances drift upwards unnoticed.
Watch out
Common mistakes.
- Believing a policy loan is interest free because the money "belongs to you", when the insurer charges interest exactly as any other lender would.
- Ignoring the effect on the death benefit, so beneficiaries receive far less than the family assumed was in place.
- Letting interest accrue for years without checking whether the loan balance is approaching the cash value and putting the policy at risk of lapsing.
Questions
People also ask.
Do I have to repay a policy loan?
There is usually no fixed schedule, but any unpaid balance plus interest is deducted from the death benefit or the surrender value.
Is a policy loan taxable?
The loan itself is generally not treated as taxable income while the policy remains in force, though a lapse or surrender with an outstanding loan can create a taxable gain.
Can I borrow against term life insurance?
No, because term policies build no cash value, so there is nothing for the insurer to lend against.
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