When you own a life insurance policy with cash value, you have access to something called a policy loan. I’ve helped hundreds of families understand this feature, and it’s one of the most misunderstood aspects of permanent life insurance.
For a complete overview, see our comprehensive MPI guide.
A policy loan allows you to borrow money from your insurance company using your policy’s cash value as collateral. But here’s what many people don’t realize—when you take a policy loan life insurance arrangement, you’re not actually withdrawing money from your cash value. Instead, the insurance company lends you money and places a lien against your policy.
Let me walk you through how this works, when it makes sense to use it, and what you need to know before taking a policy loan.
How Policy Loans Actually Work
Think of your cash value like a bucket of water. When most people hear “policy loan,” they assume you’re taking water out of the bucket. But that’s not how it works.
When you take a policy loan, you’re not removing water from the bucket at all. The insurance company gives you a separate loan and simply puts a lien against your bucket. The bucket stays full, and in most cases, that full amount continues earning interest or dividends.
Here’s the step-by-step process:
- You request a loan from the insurance company
- The company lends you money (up to a percentage of your cash value)
- Your cash value remains in the policy as collateral
- You pay interest on the borrowed amount
- Your cash value continues to grow (in most policy designs)
This is fundamentally different from a withdrawal, where money actually leaves your policy permanently.
Types of Policy Loans
Not all policy loans work the same way. There are several types, and understanding the difference is crucial.
Traditional Policy Loans
With a traditional loan, the insurance company typically moves the amount you borrowed from your main account to a separate loan account that earns a lower, fixed rate (often around 4-6%). You pay loan interest on the borrowed amount.
Participating Loans (The Game Changer)
Some policies offer what’s called a participating loan or index loan feature. This is where things get interesting for long-term wealth building.
With a participating loan, your full cash value—including the amount you borrowed against—continues to earn the same rate of return. So if your policy is earning 8% and you’re paying 5% loan interest, you have a positive spread of 3% on the borrowed money.
I’ve seen this feature used strategically by clients who understand the math. They borrow against their cash value and reinvest it back into the policy as additional premium, creating what’s essentially leveraged growth.
When Policy Loans Make Sense
Policy loans can be incredibly useful in the right situations. Here are the most common scenarios where I’ve seen clients benefit:
Emergency Funding
Life happens—job loss, medical bills, home repairs. Policy loans provide access to money without credit checks, employment verification, or lengthy approval processes. You can often get funds within days.
Major Purchases
Some of my clients use policy loans for car purchases, home down payments, or business investments. The advantage is that you’re borrowing from yourself rather than qualifying for traditional financing.
Retirement Income
This is where policy loan life insurance strategies really shine. Instead of withdrawing money from retirement accounts (which creates taxable income), you can take policy loans. These loans generally aren’t treated as taxable income, which can be a significant advantage in retirement.
Avoiding Market Volatility
During market downturns, taking policy loans allows you to access money without selling investments at a loss. Your cash value stays protected while you ride out the storm.
The Tax Advantages
One of the biggest benefits of policy loans is the tax treatment. Unlike withdrawals from most retirement accounts, policy loans are generally not considered taxable income.
This means you can access substantial amounts of money without:
- Triggering higher tax brackets
- Affecting Social Security taxation
- Creating taxable events
- Facing early withdrawal penalties
However, there’s an important caveat: if your policy lapses or is surrendered while loans are outstanding, the loan amount could become taxable income. This is why proper planning and policy management are essential.
Interest Rates and Repayment
Policy loan interest rates are typically much lower than credit cards or personal loans. Most companies charge between 4-8%, and the rate is often fixed or varies slowly over time.
Here’s what’s flexible about repayment:
- No required payment schedule (though interest compounds if not paid)
- Pay interest only to keep the loan from growing
- Pay back principal and interest to restore full cash value
- Never pay it back (it reduces the death benefit instead)
This flexibility is unique compared to traditional loans that demand monthly payments regardless of your financial situation.
Risks and Considerations
While policy loans are powerful tools, they’re not without risks. I always make sure my clients understand these potential downsides:
Policy Lapse Risk
If loan interest compounds without payments and the total loan amount approaches your cash value, your policy could lapse. This would eliminate your life insurance coverage and potentially create a large tax bill.
Reduced Death Benefit
Outstanding loans reduce the death benefit paid to your beneficiaries. If you borrow $50,000 and don’t repay it, your beneficiaries receive $50,000 less.
Opportunity Cost
Money borrowed isn’t earning returns in your policy (except with participating loan features). You need to consider whether the use of funds justifies this opportunity cost.
Policy Loan vs. Withdrawal: Key Differences
Many people confuse policy loans with withdrawals. Here’s how they differ:
Policy Loans:
- Cash value remains in policy
- Generally not taxable
- Flexible repayment
- Reduces death benefit if unpaid
- Interest charges apply
Withdrawals:
- Money leaves the policy permanently
- May be partially taxable
- Can’t be “repaid”
- Permanently reduces death benefit
- No interest charges
For most situations, loans are more favorable than withdrawals because they preserve more of your policy’s long-term value.
Maximizing the Benefits
To get the most from policy loan life insurance strategies, consider these approaches:
Understand Your Policy Type
Whole life policies typically offer traditional loans with guaranteed loan rates. Universal life policies may offer more flexible loan options, including participating loan features.
Plan for Interest Payments
Even if you’re not required to make payments, paying at least the annual interest prevents the loan from growing. This preserves more of your death benefit and reduces lapse risk.
Consider the Timing
Policy loans work best when your cash value has had time to grow. Taking large loans in the early policy years can stress the policy’s performance.
Work with Your Agent
Policy loan strategies can be complex. I always review loan scenarios with clients before they borrow to ensure they understand the long-term implications.
Hypothetical Example
Here’s how this strategy might work in practice. Consider someone age 55 who has built up significant cash value over 15 years. If they wanted to start a small business, instead of cashing out investments or getting a bank loan, they could take a policy loan.
Their cash value would continue earning dividends while they use the loan for business purposes. If the business generates enough income to service the loan interest, they could eventually pay back the principal. Their life insurance would stay intact, the death benefit would be fully restored, and they would have avoided triggering any taxable events.
Common Misconceptions
I encounter several misconceptions about policy loans that are worth addressing:
“It’s borrowing from yourself” Not exactly. You’re borrowing from the insurance company using your cash value as collateral. This distinction matters for tax and legal purposes.
“Interest payments are wasted” The interest you pay goes to the insurance company, but it helps keep their overall costs down, which can benefit all policyholders through better dividend performance.
“You can borrow 100% of cash value” Most companies limit loans to 90-95% of cash value to protect against policy lapse.
When Policy Loans Don’t Make Sense
Policy loans aren’t always the right choice. I typically discourage them when:
- The policy is new with minimal cash value
- You’re unlikely to maintain the policy long-term
- You need the money for speculative investments
- You’re unable to pay at least the annual interest
- Other financing options are significantly cheaper
- Understand that policy loans don’t actually withdraw money from your cash value—the insurance company lends you money and places a lien against your policy while your cash value stays intact and continues growing.
- Look for policies with participating loan features that allow your full cash value to keep earning returns even on the borrowed amount, potentially creating positive arbitrage when earnings exceed loan interest rates.
- Use policy loans for emergencies, major purchases, or business opportunities since they require no credit checks, employment verification, or lengthy approval processes and funds are typically available within days.
- Remember that unpaid loan interest compounds and gets added to your total loan balance, so develop a repayment strategy to prevent the loan from growing beyond your cash value.
- Consider policy loans as an alternative to traditional financing that lets you access your money without disrupting your policy’s growth potential, unlike withdrawals which permanently reduce your policy value.
The Bottom Line
Policy loan life insurance features can be powerful tools for financial flexibility, tax-advantaged access to funds, and retirement income planning. But they require understanding and proper management to be effective.
The key is working with someone who can help you understand how loans will affect your specific policy and financial situation. Every policy is different, and what works for one person may not work for another.
If you’re considering a policy loan or want to understand how this feature might fit into your financial strategy, I’d be happy to review your specific situation. As an independent agent, I can help you understand your options and make sure any loan strategy aligns with your long-term goals.
Related Reading
- Retirement Income Solutions: What You Should Know
- LIRP Life Insurance: What You Should Know
- MPI Investment: What You Should Know
- Benefits of IUL: What You Should Know
Ready to explore your policy loan options? I work with multiple top-rated carriers and can help you understand how policy loans might fit into your financial strategy. Let me review your situation and explain your options clearly.
