Policy Loans: How Borrowing Against Cash Value Works and the Risks

How life insurance policy loans work, what they do to the death benefit, how they raise lapse risk, and when a loan can turn into a tax bill.

Life Insurance on Review · Last reviewed October 26, 2026 · 5 min read

If your permanent life insurance policy has cash value, you can usually borrow against it from the insurer. That makes policy loans a handy source of cash, and they are often described as tax-free.

That description is only partly true. A policy loan reduces what your beneficiaries receive, accrues interest, can push a policy toward lapse, and can create a tax bill if the policy ends while the loan is outstanding. Understanding those mechanics is the difference between using a loan well and quietly hollowing out your coverage.

This guide is general information, not financial, insurance, tax or legal advice. Your policy's loan provision, your insurer's figures and a tax professional's review should guide your actual decision.

How a policy loan works

New York's Department of Financial Services explains that you may make a loan against the cash value of a policy at a specified or variable rate of interest. You're borrowing from the insurer, with your policy's value as collateral. The California Department of Insurance's guide defines loan value as the amount the owner can borrow using the policy's value as collateral, and says the cash value can be used as collateral at the interest rate specified in the policy. Its glossary adds that the rate usually varies based on an index defined in the policy.

Key points to confirm in your contract:

How much you can borrow (the loan value).
The interest rate, whether it is fixed or variable, and how it is set.
When interest is due, and whether unpaid interest is added to the loan balance.
Whether loans affect dividends or interest credited on the borrowed portion of your cash value.

If a loan is connected to replacing your policy, the NAIC's 2015 replacement model requires your existing insurer, when you ask to borrow, to send a notice advising that releasing policy values may affect the policy's guaranteed elements, non-guaranteed elements, face amount or surrender value. Read it; it's a short reminder of everything below.

What a loan does to the death benefit

An unpaid loan doesn't disappear. The NAIC's consumer guidance explains that any loans you have not repaid, plus interest, will be subtracted from the death benefit. The California guide likewise says outstanding loans are deducted from policy proceeds at death or at policy surrender. Your beneficiaries could receive noticeably less than the face amount you had in mind.

Loans and lapse risk

This is the risk that catches people. Investor.gov's bulletin on variable life insurance explains that policy loans reduce cash value and increase the likelihood that a policy will lapse. A policy can lapse if there isn't enough cash value, because of fees, poor investment performance or loans, to pay current charges.

For universal life, the Texas Department of Insurance's guide (updated December 2025) explains that when premiums are lower than the cost of insurance, the difference comes out of the cash value, and if the cash value reaches zero, the policy could lapse. A growing loan balance and accruing interest shrink the margin.

To manage that risk:

Ask for an in-force illustration showing the loan, assumed interest, and how long the policy will last.
Pay at least the loan interest each year if you can.
Compare the loan balance with the cash value on every annual statement.

When a loan becomes taxable

For most life insurance policies, borrowing isn't a taxable event. Investor.gov says policy loans, unlike withdrawals, are not generally considered taxable events, and the Washington State Office of the Insurance Commissioner says a policy loan won't be taxable, with an exception if the policy terminates before you've repaid the loan.

That exception is the trap. Investor.gov explains that if a policy lapses with a loan outstanding, the loan may be treated as a withdrawal for federal tax purposes. IRS Publication 525 (2025) explains why: when a policy is surrendered, your cost in the contract is reduced by unrepaid loans that weren't included in income, so a large outstanding loan can mean a tax bill even when the check you receive is small.

Modified endowment contracts follow stricter rules

A policy that's paid in too much, too fast, can be classified as a modified endowment contract (MEC). Under 26 U.S.C. 7702A (2024 edition of the U.S. Code), a policy entered into on or after June 21, 1988 that fails the "7-pay test" during its first seven contract years is a MEC, and a contract received in exchange for a MEC is also a MEC.

The tax difference is significant. Under 26 U.S.C. 72(e)(10) (2024 edition), loans from a MEC are treated as amounts received under the contract, which can make them taxable to the extent of any gain. And under 26 U.S.C. 72(v) (2024 edition), the taxable portion generally carries an additional 10% tax, with exceptions for amounts received at or after age 59½, on disability, or as part of certain substantially equal periodic payments. If you don't know whether your policy is a MEC, ask the insurer before you borrow.

Loans used to buy another policy

Using loans from one policy to pay premiums on a new one is called a financed purchase, and under the NAIC's 2015 replacement model it counts as a replacement. FINRA's 2023 guidance on policy exchanges warns that borrowing from an existing policy will almost certainly reduce its death benefit and can make it harder to keep the original policy in force. If you can't keep it in force, you lose the protection, and the loans themselves might create tax consequences.

Questions to ask before you borrow

What is my current loan value, interest rate and interest due date?
Is my policy a MEC?
How does the loan affect dividends or credited interest?
How long will the policy last if I pay only the interest, or nothing?
What would my beneficiaries receive with this loan outstanding?

If the answers are hard to get, your state insurance department can help you understand your rights under the contract.

Key takeaways

A policy loan borrows from the insurer against your cash value at the interest rate your policy sets.
Unpaid loans and interest are subtracted from the death benefit your beneficiaries receive.
Loans reduce cash value and raise the risk of lapse, especially in universal and variable life.
Loans are generally not taxable, but if the policy lapses or is surrendered with a loan outstanding, you may owe tax.
Loans from a modified endowment contract can be taxable and may carry an additional 10% tax under 26 U.S.C. 72(v) (2024 edition).

Sources

Our articles are general information, not financial, insurance, tax or legal advice, and we don't sell insurance or recommend specific companies or products.

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