Whole life policy loans
For many people who buy a cash value whole life policy, borrowing against it is the point. Here’s exactly what happens when you take a loan, what it costs, how it affects your dividends, and how to keep it from turning into a problem.
A whole life policy loan is simpler than most people expect, and also less magical than some pitches suggest. You’re borrowing the insurer’s money, using your cash value as collateral, at a rate the contract sets. Everything else follows from that.
What happens when you borrow
Once the policy has cash value, you can borrow against it up to the loan value the contract sets, with no credit check or approval process; you send the insurer a loan request. The insurer lends you its own money and holds your cash value as collateral. Funds usually arrive within a few business days.
Your cash value stays in the policy, but the part securing the loan isn’t available to borrow again or to surrender until you repay. The policy keeps its guaranteed cash value schedule, and the death benefit stays in force while the policy is in force, reduced by the loan balance.
The loan rate
The contract sets the loan rate. It’s usually one of two kinds:
| Type | How it works | What to know |
|---|---|---|
| Fixed | A set rate written into the contract | Predictable for the life of the policy, whatever happens to interest rates |
| Variable | Adjusts periodically, usually tied to a published index of corporate bond yields, within limits set by the contract and state law | Can be lower than a fixed rate when rates are low, and higher when they rise |
Interest is charged on the balance and is usually due once a year. Interest you don’t pay is added to the loan, so it compounds.
Direct and non-direct recognition
This is one of the biggest differences between carriers’ whole life loans. Carriers handle loans and dividends in one of two ways.
With non-direct recognition, the dividend is figured the same whether or not you have a loan outstanding. With direct recognition, the dividend on the borrowed portion of cash value is adjusted, up or down, based on the loan rate. Either way, dividends are not guaranteed (the insurer sets them each year and can reduce or skip them), and loan interest keeps accruing.
Neither method is better in every case. What a loan really costs depends on the loan rate (fixed or variable), how the carrier’s dividend responds, and the dividend scale in future years, and these differ by carrier. The method should match how you plan to borrow, and the carrier’s current product guide is where to confirm it.
What a loan really costs
The headline cost is the loan rate. The full cost also includes what happens to the dividend on the borrowed cash value, which depends on the recognition method, and the compounding of any interest you don’t pay. Your illustration can show a loan and its repayment so you can see the effect on cash value and death benefit, on guaranteed and non-guaranteed values, before you borrow.
Loan interest is paid to the insurer, not into your policy or back to you. What repaying a loan does is free up the cash value that was securing it, so you can borrow it again. That’s valuable on its own, and it’s the mechanism the banking concept is built on.
Repaying, or not
There’s no required repayment schedule. You can repay on your own timeline, in any amounts, or not at all. Repaying restores what you can borrow next time.
Not repaying has consequences. Unpaid interest is added to the loan, the balance is subtracted from the death benefit, and the loan keeps growing while it’s out. Some people choose to leave a loan in place and let the death benefit settle it. That can work, as long as the loan balance stays well inside what the cash value can carry.
When a loan becomes a problem
If the loan grows larger than the cash value, the policy can lapse, and the gain can become taxable. The insurer will send notices before that happens, and you can usually stop it by paying interest or part of the balance.
The risk is highest when a large loan sits for years with interest compounding and nobody watching. Paying at least the annual interest keeps the balance from growing. An in-force illustration each year shows where the loan is heading.
How loans are taxed
Under current tax law, a loan is generally not taxable income while the policy stays in force and is not a modified endowment contract (MEC). If a policy with an outstanding loan lapses or is surrendered, the loan is treated as paid from the cash value, and any gain above your cost basis can be taxable, even though you received the cash years earlier.
If the policy is a MEC, loans are taxed gain-first and can carry a 10% penalty before age 59½. That’s why cash value designs are funded to stay inside the federal limits.
Good borrowing habits
- Know the recognition method and loan rate before you borrow.
- Pay at least the annual interest if you don’t plan to repay principal soon.
- Set a repayment plan for each loan, especially for purchases you’d otherwise finance.
- Leave room. Don’t borrow right up to the loan value.
- Review an in-force illustration every year while a loan is outstanding.
Questions we hear about whole life loans.
Do I need good credit to borrow?
No. There’s no credit check or approval process. You send the insurer a loan request, up to the loan value the contract sets.
Does my cash value stop growing while I have a loan?
The guaranteed cash value schedule continues. How the dividend responds depends on the carrier: with non-direct recognition it’s figured the same; with direct recognition the dividend on the borrowed portion is adjusted, up or down. Dividends aren’t guaranteed either way, and loan interest accrues.
What happens to a loan when I die?
The outstanding balance, including unpaid interest, is subtracted from the death benefit, and your beneficiaries receive the rest.
Can I borrow for anything?
Yes. The insurer doesn’t ask what the money is for. A car, a renovation, a business expense, or an emergency are all things people borrow for.