Who Gets the Interest on a Life Insurance Loan?

Life insurance policies that accumulate cash value offer a unique financial tool: the ability to borrow against the policy. These loans function differently from traditional bank loans. Understanding how interest on these loans operates, and specifically who benefits from it, is essential for policyholders considering this option.

Basics of Life Insurance Loans

A life insurance loan allows a policyholder to access funds using the accumulated cash value within a permanent life insurance policy, such as whole life or universal life. Permanent policies have a savings component that grows over time. This cash value serves as the source of the loan, distinguishing it from conventional loans.

When a loan is taken, the policy’s cash value acts as collateral, providing security for the loan amount. The policyholder is essentially borrowing from the insurance company, but the funds are backed by their own policy’s value. There is no credit check or approval process, as the loan is secured by the policy’s assets.

The Interest Mechanism

When an insurance company charges interest on a life insurance loan, it is not primarily for profit in the way a bank earns profit from a traditional loan. Instead, the interest serves a specific function related to the policy’s long-term financial integrity. The underlying cash value of the policy continues to earn interest or dividends, even while a loan is outstanding.

The interest ensures that the policy’s cash value can continue to grow, or at least not diminish below the loan amount. This mechanism helps protect the policy’s guaranteed growth rates and the eventual death benefit. The interest maintains the policy’s solvency and ensures the death benefit is not prematurely eroded by the loan.

How Interest is Calculated and Applied

Interest on life insurance loans is calculated based on either a fixed or variable rate, depending on the terms of the policy. This interest commonly compounds annually, meaning unpaid interest is added to the principal balance of the loan, causing the overall loan amount to increase. Policyholders usually receive a bill for the accrued interest annually.

If the policyholder does not pay the interest when billed, the unpaid amount is added to the outstanding loan principal. This increases the total loan balance, which continues to accrue interest.

Consequences of Unpaid Loan Interest

Failing to pay the accrued interest on a life insurance loan can lead to significant implications for the policy. Unpaid interest is added to the outstanding loan principal, which causes the total loan balance to grow. This accumulation of unpaid interest and principal means the loan balance can eventually approach or exceed the policy’s cash value.

If the outstanding loan balance, including accumulated interest, surpasses the policy’s cash value, the policy may lapse. A policy lapse with an outstanding loan can trigger adverse tax consequences. The loan amount, to the extent it exceeds the premiums paid into the policy, may become taxable income to the policyholder.

Repaying Your Life Insurance Loan

Policyholders have several options for repaying a life insurance loan. They can make periodic payments that include both principal and interest, or they can choose to pay only the interest, allowing the principal balance to remain outstanding. Another option is to repay the entire loan balance in a single lump sum.

Some policyholders may choose not to repay the loan during their lifetime. In such cases, any outstanding loan balance, along with accrued interest, is deducted directly from the death benefit paid to beneficiaries upon the insured’s passing. Repaying the loan helps restore the policy’s cash value and preserves the full death benefit for beneficiaries.