Borrowing Against Life Insurance Cash Value and What Lapses a Policy

A policy loan is the insurer lending against your cash value: interest compounds, an unpaid balance reduces the death benefit, and a loan that outgrows the account can lapse it.

Borrowing against life insurance means the insurance company lends you money with your policy’s cash value as collateral: no credit check, no bank, and no fixed repayment schedule in the contract. It is not a withdrawal, because the cash value stays inside the policy, and it is not free, because interest accrues and compounds. Any unpaid loan plus interest comes off the death benefit, and a loan that outgrows the cash value can lapse the policy and leave you owing income tax on gain you never saw in cash.

Key takeaways

• A policy loan is money the insurer lends against cash value with no credit check; the NAIC states that “Any loans you have not repaid (plus interest) will be subtracted from the death benefit” (NAIC; MoneyGeek).
• Policy loans and withdrawals up to basis are generally not subject to income tax while the policy stays in force and is not a modified endowment contract (MEC); on a lapse or surrender with a loan out, “you must include in income any proceeds that are more than the cost of the life insurance policy” (IRS Publication 525, 2025).
• One carrier’s help page describes a participating fixed loan at “a fixed loan rate of 5%” that keeps earning index credits, a participating variable loan, and a standard “wash loan” where the rate charged equals the rate credited (carrier loan help page).
• Under NAIC Actuarial Guideline 49-A an illustration may not show the rate credited on loaned money beating the loan rate by more than 50 basis points (NAIC AG 49-A, adopted December 11, 2025).
• If a policy is a MEC under the 7-pay test of 26 U.S.C. 7702A, a loan is taxed as a distribution, income-first, with a 10% additional tax before age 59 1/2 (26 U.S.C. 72).
• An overloan protection rider can turn a heavily borrowed policy into paid-up insurance, usually only after 15 years in force, and “Neither the IRS nor the courts have ruled on the tax consequences” of using it (NY Department of Financial Services, 2013).

What is a life insurance policy loan?

A life insurance policy loan is a loan from the insurer, secured by the cash value of a permanent policy (whole, universal or indexed universal life), taken with no credit check and repaid on your own schedule (MoneyGeek; Experian). Term insurance has no cash value, so there is nothing to borrow against; the feature belongs to permanent policies, which is part of why they cost more (see indexed universal life insurance explained).

It is not a withdrawal: the cash value stays in the policy and, depending on the loan type, keeps earning, while the loan sits on its own ledger. It is not free: interest runs from the day the money goes out, and unpaid interest is added to the balance and charged interest itself. It is not income while the policy stays in force and is not a MEC. And it is optional to repay; the contract sends no bill, but “If you don’t pay back the loan, it will lower the amount of the death benefit” (Texas Department of Insurance, December 2025). Your beneficiaries receive the death benefit, generally income-tax-free to them under current law (26 U.S.C. 101(a)), minus what you owe.

How does interest work on a policy loan, and what is an indexed or wash loan?

The loan rate is set by the contract, not your credit score, and it compounds. A physician who sat through an IUL pitch reports loan interest of about 5% to 6% (White Coat Investor); the rate that matters is the one in your contract, and whether it can move.

Most carriers offer more than one loan type. One carrier’s product help page lays out three (carrier loan help page): a standard or wash loan, “where the loan rate charged is equal to the loan rate credited,” so there is no spread to win or lose; a participating fixed loan at “a fixed loan rate of 5%” where “Loaned money will be transferred to an Indexed Loan Account” and keeps earning index credits; and a participating variable loan, where “A Variable Loan Rate is charged on the loan balance.”

The participating (indexed) loan is the one the sales slide loves: borrow at the loan rate, keep earning index credits on the borrowed money, pocket the spread. Two facts cut it down. In a flat or down year the index credit is 0% while the loan rate is charged in full, so the spread runs backwards for as many years as the index disappoints, with the policy’s monthly charges coming out the whole time. And regulators capped the slide: under AG 49-A, “the illustrated Policy Loan Interest Credited Rate shall not exceed the illustrated Policy Loan Interest Rate by more than 50 basis points” (NAIC AG 49-A, Section 6). For a tradesman bridging a slow winter, the wash or fixed loan has a cost that fits on a napkin; the indexed loan is a bet on the index with your death benefit as the stake.

What happens if you don’t pay back a life insurance loan?

If you never repay a policy loan, either you die with it outstanding and the insurer subtracts the balance plus interest from the death benefit, or the balance outgrows the cash value first and the policy lapses. The first is a smaller check for your family. The second can add a tax bill.

How an unpaid loan lapses a policy:

1. The balance compounds every year you skip the interest, while cost of insurance (rising with age), policy fees and rider charges keep coming out of the cash value whether or not the index credits anything.
2. The insurer’s annual report estimates how long the policy may last (Texas Department of Insurance); the NAIC warns, “If you take cash value out, there may not be enough to pay premiums” (NAIC).
3. When the balance catches the cash value, a premium comes due. Miss it and the usual 31-day grace period runs; “If you don’t pay the premium within the grace period, your policy will lapse” (Texas Department of Insurance, December 2025).
4. On lapse the loan is repaid from the cash value. You receive nothing, but the IRS treats it like a surrender: “you must include in income any proceeds that are more than the cost of the life insurance policy” (IRS Publication 525, 2025). Everything above the premiums you paid in, including borrowed money spent years ago, is taxable gain that year.
5. Reinstatement is usually possible within five years with back premium, interest and possibly health questions (Texas Department of Insurance), but a loan-driven lapse usually leaves no cash to do it with.

A policy loan that only ever gets bigger is not a loan; it is a slow surrender with the tax bill saved for last.

Is it better to withdraw or borrow from cash value?

Neither is better in general: a loan keeps the policy whole and charges interest, a withdrawal costs no interest but permanently removes cash value and usually lowers the death benefit, and a surrender ends the coverage. For a policy that is not a MEC, 26 U.S.C. 72(e)(5) treats withdrawals as a return of your premiums first (basis first), so nothing is taxed until the total taken out exceeds what you paid in; loans are not distributions at all while the policy stays in force and is not a MEC; a surrender is taxed on proceeds above cost (IRS Publication 525).

	Policy loan	Withdrawal	Full surrender
Cash value	Stays in the policy as collateral	Permanently reduced	Policy ends; you get the surrender value less charges and any loan
Death benefit	Reduced by the unpaid balance plus interest (NAIC)	Usually reduced by the amount withdrawn (NAIC)	Coverage ends
Tax, not a MEC	Not taxed while in force; gain taxable on lapse or surrender (IRS Publication 525)	Basis first; gain above premiums paid is taxable (26 U.S.C. 72(e)(5))	Proceeds above cost are taxable (IRS Publication 525)
Tax, MEC	Distribution, income-first, 10% additional tax before 59 1/2 (26 U.S.C. 72)	Income-first, same 10% additional tax (26 U.S.C. 72)	Gain taxable, 10% additional tax under 59 1/2 (26 U.S.C. 72)
Charges	Loan interest compounds	Possible surrender fee “if you withdraw the money early” (Texas Department of Insurance); some contracts charge per withdrawal, $25 in one critic’s schedule (Personal Finance Club)	Surrender charges in the early years; “very costly if you quit during the early years of the policy” (NAIC)

Early-year surrender math is brutal: one r/personalfinance poster described a relative paying $400 a month, about $11,000 in, with a surrender value around $2,000 (r/personalfinance). If the policy is wrong for you, “Never cancel life insurance until you have it replaced by another policy in force” (r/personalfinance), and do not let a loan limp along until it lapses.

What is the MEC trap, and how does it change a loan?

A modified endowment contract (MEC) is a life insurance policy that took in too much premium too fast, and once a policy is a MEC its loans stop being loans for tax purposes. Under 26 U.S.C. 7702A a policy fails the 7-pay test if premiums paid in the first seven contract years exceed the level annual premiums that would have paid it up in seven. Then 26 U.S.C. 72 treats “any amount received as a loan” as a distribution, taxed income-first, with a 10% additional tax before age 59 1/2 unless you are disabled or take substantially equal periodic payments.

Tradesmen stumble into it two ways: a good year’s overtime poured into a policy with a death benefit too small to carry it, and a later death benefit increase, a “material change” that restarts the 7-pay test (26 U.S.C. 7702A©(3)). Funding near the line builds cash value fastest; the mistake is nobody tracking the line. Ask the carrier, in writing, whether your policy is a MEC before you borrow.

What does an overloan protection rider do, and what does it not do?

An overloan protection rider, once exercised, turns a heavily borrowed policy into paid-up life insurance so it cannot lapse from the loan, and it is narrower than the pitch suggests. New York’s regulator describes the typical conditions: the policy in force “usually 15 years,” the insured at a minimum age, and the policy not a MEC at issue; once exercised “the policy will automatically become paid up life insurance” (NY Department of Financial Services, 2013).

What the rider does not do: settle the tax question, since carriers must disclose that “Neither the IRS nor the courts have ruled on the tax consequences of exercising the overloan protection rider” and that a court “could assert that the policy has been effectively terminated” (NY Department of Financial Services); help in the years you are most likely to borrow, since a rider that needs 15 years in force is no use to a pipefitter six years in; or restore the death benefit, since paid-up insurance after a large loan is a small policy with a large lien on it.

When does a policy loan make sense for a tradesman?

A policy loan makes sense when the need is short, the amount is small next to the cash value, and you have a plan to repay at least the interest; it makes no sense as a second paycheck, a stand-in for savings, or a way to pay the policy’s own premium. Explainers written for people with maxed-out retirement accounts skip this part, so here it is for a household on seasonal hours and a truck note.

Where a policy loan can fit: a slow-season bridge, such as a framer laid off in January with real cash value built up and a plan to repay from spring overtime; an engine job on the work truck that keeps the income coming; a gap between jobs for a 1099 contractor with no group benefits to fall back on (see life insurance for self-employed tradesmen).

Where it does not fit: funding a lifestyle, since a loan taken every year and never repaid is exactly how an unpaid loan lapses a policy; standing in for savings, since early-year cash value is thin because charges are front-loaded; paying the premium with loans for years; and retirement income on the pitch deck’s schedule, which works only if the policy was funded well for decades and watched every year (the trade-offs are in IUL vs 401(k), Roth IRA and pension and retiring early from the trades). Before any of that, the question is whether you have the right coverage at all; the guide to life insurance for blue collar workers starts there.

What should you check before taking a policy loan?

Before taking a policy loan, get the numbers in writing, because the real cost depends on your contract’s loan type, rate and crediting.

1. Ask for an in-force illustration that includes the loan. Texas’s Office of Public Insurance Counsel tells universal life owners to “Review your policy every year” and “Ask for an ‘inforce illustration’” (Texas Office of Public Insurance Counsel). Have it rerun one or two points lower with the cap reduced; illustrated rates are governed by AG 49-A and are not a prediction.
2. Know the loan type and rate: fixed, variable, participating or wash, the rate charged, the rate credited on loaned money, and whether either can change.
3. Confirm in writing that the policy is not a MEC.
4. Plan the repayment before the money moves: at least the interest every year, and a date for the principal.
5. Set the loan-to-cash-value point at which you stop borrowing, using the insurer’s annual estimate of how long the policy may last (Texas Department of Insurance).
6. Check for an overloan protection rider and read its conditions.

If someone is pitching the loan feature as the reason to buy a permanent policy, slow down: a policy loan is a side benefit of coverage you needed anyway, not a reason to pay permanent premiums instead of term. You can check what you qualify for in about a minute, then ask the independent licensed agent for the loan provisions, the guaranteed elements column and the charge schedule side by side. Blue Collar Workers Covered is not an insurance company and not a licensed insurance agency; it connects consumers with independent licensed insurance agents, who provide all quotes, advice and coverage (how Blue Collar Workers Covered works). If you already own a policy, the same minute gets you to an agent who can read your in-force illustration with you.

Frequently asked questions

Can you borrow against an IUL?

Yes. An IUL is permanent insurance with a cash value account, and you can borrow against it with no credit check on the contract’s terms, which may include a fixed, variable, participating (indexed) or wash loan (carrier loan help page). Early-year cash value is thin because charges are front-loaded, so there may be little to borrow.

Do you have to pay back a life insurance loan?

No, the contract sets no repayment schedule, but the balance plus interest comes off the death benefit if you die with it outstanding, and if it grows past the cash value the policy can lapse (NAIC; Texas Department of Insurance). Paying at least the interest every year keeps the balance from compounding.

What happens if I never repay a policy loan?

Either your beneficiaries receive the death benefit minus the loan and interest, or the loan outgrows the cash value and the policy lapses. On a lapse the IRS taxes proceeds above the cost of the policy as income, even though you receive no cash (IRS Publication 525, 2025).

Is a life insurance loan taxable?

Policy loans are generally income-tax-free under current law while the policy stays in force and is not a modified endowment contract (MEC); if it lapses or is surrendered with the loan out, the gain above your basis becomes taxable (IRS Publication 525). If the policy is a MEC, a loan is taxed as a distribution, income-first, with a 10% additional tax before age 59 1/2 (26 U.S.C. 72).

Is it better to withdraw or borrow from cash value?

It depends on whether you plan to keep the policy. A loan keeps the cash value in place and charges interest; a withdrawal costs no interest but permanently lowers the cash value and usually the death benefit, and may carry a surrender fee in the early years (Texas Department of Insurance). Ask for an in-force illustration showing both.

This article is educational and is not individualized financial, tax, legal or insurance advice. Life insurance products are offered through independent licensed agents; product features, riders and availability vary by carrier and state. Cash value growth in an indexed universal life policy is not guaranteed, policy charges apply, and policy loans and withdrawals reduce the cash value and death benefit and may have tax consequences. Tax statements reflect current federal law and general treatment; consult a tax professional about your situation.