Grow · 5 min read
Policy loans vs bank loans
How borrowing against your own policy compares with a bank loan on cost, flexibility, credit, tax and risk, with the lapse trap explained.
Pillar: Grow · Reading time: 5 min
In plain words
When you borrow from a bank, the bank checks your credit, sets a payment schedule and charges interest. When you borrow against your cash-value life insurance, what planners call a policy loan, the insurer lends you its money and holds your cash value as collateral. There is no credit check, no fixed schedule and no question about why you want the money.
That makes a policy loan flexible. It does not make it free. The right choice depends on the rate, the purpose and your discipline.
How a policy loan works
- You ask the insurer for a loan, up to a limit. The limit is often 90% or more of your cash value, depending on the policy.
- The insurer sends the money. Your cash value stays in the policy as collateral.
- Interest accrues at the policy's loan rate. If you do not pay it, it is added to the loan balance.
- You repay whenever and however you like.
- Any loan still outstanding at death is subtracted from the death benefit.
Because the cash value stays in the policy, it can keep earning the guaranteed rate and any dividends or index credits, depending on the loan type.
Types of policy loan
- Fixed-rate loan. The rate is set in the contract. Simple and predictable.
- Variable-rate loan. The rate moves with a published benchmark, within limits.
- Wash or zero-cost loan. Some policies, often after a certain year, credit the borrowed cash value at or near the loan rate, so the net cost is close to zero.
- Indexed or participating loan (mostly in IUL). The borrowed cash value keeps earning index credits while you pay a set loan rate. If credits beat the rate you gain; if they fall short, you lose. This adds risk.
In whole life, also ask about direct vs non-direct recognition: whether the dividend on borrowed cash value is adjusted for the loan.
Side by side
| Policy loan | Bank or auto loan | |
|---|---|---|
| Approval | No credit check | Credit check, income proof |
| Credit report | Not reported | Reported |
| Schedule | You choose | Fixed payments |
| Collateral | Your cash value | The car, house or nothing |
| Rate | Set by the policy, often 5-8% | Market rate by credit and term |
| Your money while borrowed | Can keep earning inside the policy | Spent; no earnings |
| Tax | Generally not taxable income from a non-MEC in force | Not taxable; interest rarely deductible for personal use |
| Main risk | Unpaid loan grows; policy can lapse | Late fees, credit damage, repossession |
The lapse trap
This is the risk people underplay. If you never pay interest, the loan grows every year. If the loan plus interest catches up with the cash value, the policy can lapse. Under current U.S. federal law, a lapse or surrender with a loan outstanding can create taxable income equal to the gain in the policy, even though you receive no cash at that point. People call it a tax bomb.
The fix is simple: pay at least the interest, watch the loan-to-value ratio every year, and repay on a plan.
A worked example (illustrative)
Nadia, 45, needs $25,000 for a car. She has $90,000 of cash value in a whole life policy she has funded for nine years. All numbers are illustrative only, not a quote.
| Policy loan | Auto loan | |
|---|---|---|
| Rate | 6% | 7.5% |
| Term | 4 years, self-imposed | 4 years |
| Monthly payment | about $587 | about $605 |
| Total interest | about $3,200 | about $4,000 |
| Cash value earning while borrowed | Yes, on $90,000 | n/a |
If Nadia keeps paying $605 a month to her policy, the extra rebuilds her pool a little faster. If she stops paying, the loan grows, her death benefit shrinks and, over many years, lapse becomes possible. The policy loan is better only if she behaves like a good bank customer to her own policy.
When a bank loan is the better choice
- A 0% or very low promotional rate beats almost any policy loan rate.
- A mortgage can make sense for a home, where the term is long and the rate may be low.
- You want the structure of fixed payments.
- Your cash value is small and borrowing would push the loan-to-value ratio too high.
Common mistakes
- Never repaying. The loan compounds and erodes the death benefit.
- Ignoring the net cost. Compare the loan rate with what the borrowed cash value still earns.
- Borrowing from a MEC. Loans from a modified endowment contract can be taxable and may face a 10% penalty before 59½.
- Borrowing to the limit. Leave a buffer so interest does not push the policy toward lapse.
- Not checking the annual statement. Watch the loan balance and cash value every year.
FAQs
Does a policy loan hurt my credit?
No. Policy loans are not reported to credit bureaus, and there is no credit check.
Do I have to repay a policy loan?
There is no required schedule. Any balance is taken from the death benefit. Repaying keeps the policy healthy and restores your borrowing pool.
Is the interest tax-deductible?
For personal use, generally no. Business use can differ; ask a tax professional.
Can my cash value keep growing while I borrow?
In most designs, yes, at the guaranteed rate plus dividends or credits. Direct recognition policies may adjust dividends on the borrowed part.
What loan-to-value ratio is safe?
There is no single number, but many owners aim to keep loans well below the cash value, leaving room for years of accrued interest.
Related strategies
- How infinite banking works, step by step — the full borrowing cycle.
- What a MEC is and how to avoid one — why tax treatment of loans depends on it.
- Velocity of money — why keeping capital working matters.
Next step
Check whether your cash flow and safety net can support this kind of borrowing with the Wealth Strategy Score at /score.
Education only, not personal financial, tax, legal or insurance advice. VeraLife.ai is not a registered investment adviser, broker-dealer or insurance agency. All numbers are illustrative.