What Is the Interest Rate on a Life Insurance Loan?

Permanent life insurance policies offer policyholders a unique financial tool: the ability to borrow against the policy’s accumulated cash value. These life insurance loans operate differently from traditional bank loans, presenting distinct characteristics regarding their interest rates and repayment structures. Understanding these nuances is important.

Understanding Life Insurance Loans

A life insurance loan is taken against the cash value component of a permanent life insurance policy, such as whole life, universal life, or indexed universal life. It is not a withdrawal, which permanently reduces the policy’s value, nor is it a loan from a bank. Instead, the insurance company lends the policyholder money, with the policy’s cash value serving as collateral for the loan.

The policy remains in force while the loan is outstanding, and the cash value continues to grow, though the loan balance will reduce the net cash value available. Policyholders often consider these loans because they typically do not require a credit check or a lengthy approval process, offering a flexible way to access liquid assets. This access can be particularly useful for various financial needs, from unexpected expenses to educational costs, without impacting one’s credit score.

How Interest Rates are Determined

The interest rates on life insurance loans can be either fixed or variable, depending on the specific policy terms set by the insurer. A fixed interest rate is established at the time the loan is initiated and remains constant throughout the loan’s duration, providing predictability in repayment.

Conversely, a variable interest rate fluctuates over time, typically tied to an external financial index such as the Moody’s Corporate Bond Yield Average. These variable rates often have a cap, limiting how high the rate can go, and a floor, preventing it from dropping below a certain point. Factors influencing the specific rate offered include the type of policy, the insurer’s internal policies, and prevailing market conditions. Interest on these loans generally accrues daily and is billed to the policyholder annually, becoming part of the outstanding loan balance if not paid.

Impact of Unpaid Interest on Your Policy

If the interest on a life insurance loan is not paid, it is typically added to the outstanding loan principal, causing the total loan balance to increase. This growing loan balance directly reduces the policy’s available cash value, which in turn diminishes the death benefit payable to beneficiaries. If the policyholder passes away with an outstanding loan, the beneficiaries will receive a reduced payout.

A significant consequence of unpaid interest and a growing loan balance is the risk of a policy lapse. If the total amount of the loan, including accumulated interest, exceeds the policy’s cash value, the insurance company may terminate the policy. Should a policy lapse under these circumstances, the policyholder could face income tax liability on the amount borrowed that exceeds the policy’s cost basis.

Managing and Repaying Your Life Insurance Loan

A distinguishing feature of life insurance loans is their flexible repayment terms. Unlike most conventional loans, there are typically no fixed repayment schedules or mandatory monthly payments. Policyholders have the discretion to repay the principal and/or interest at their own pace, or even choose not to repay the loan during their lifetime, though doing so carries the consequences outlined previously.

When a policyholder repays a life insurance loan, the policy’s cash value is restored, and the death benefit is reinstated to its original amount, assuming no other outstanding loans or withdrawals exist. This flexibility allows individuals to manage their finances according to their current circumstances, making partial payments or full repayment as their financial situation permits.