Definition

A policy loan is money borrowed from the insurance company using the policy's cash value as collateral.

Key Characteristics

• Not a withdrawal: Cash value remains in policy as collateral
• Guaranteed right: No credit check or approval needed
• Interest charged: Loan accrues interest at rate specified in policy
• Optional repayment: No required payment schedule
• Reduces death benefit: Unpaid loan + interest deducted from death benefit

Not Really a "Loan"

• Technically: Using your own money with insurer's lien
• Collateralized: Cash value secures the advance
• Contractual right: Owner has right to access cash value this way

Typical Limits

Most policies allow:
- 90-95% of cash surrender value (CSV)
- Some allow 100% (full cash value)
- Policy specifies: Check contract for exact percentage

Why Not 100%?

• Interest cushion: Insurer needs buffer for accruing interest
• Prevents automatic lapse: Leaves room for interest before hitting cash value limit
• Administrative reserve: Small amount kept for policy maintenance

Formula

Maximum Loan Amount = Cash Surrender Value × Loan Percentage

Example 1:

Cash surrender value: $50,000
Loan percentage: 90%
Maximum loan: $50,000 × 0.90 = $45,000

Example 2:

Cash value: $75,000
Surrender charge: $2,000
Cash surrender value: $73,000
Loan percentage: 95%
Maximum loan: $73,000 × 0.95 = $69,350

Types of Interest Rates

Fixed Rate

• Set in policy: Specified when policy issued
• Typical range: 5-8% annually
• Older policies: Often have higher rates (8-10%)
• Newer policies: Typically 5-6%
• Never changes: Rate remains same for life of policy

Variable Rate

• Adjusts periodically: Changes with market conditions
• Indexed: Tied to specific index (e.g., Moody's Corporate Bond Rate)
• Formula: Index rate + spread (e.g., Moody's + 1%)
• Floor rate: Usually has minimum (e.g., 4%)
• Capped: May have maximum rate

Direct Recognition

• Adjusts cash value growth: Cash value earns different rate on loaned portion
• Two tiers: Different rates for loaned vs. non-loaned cash value
• Net cost: Reduces net cost of loan
• Example: Loan rate 6%, but loaned cash value earns 4% = net 2% cost

Annual vs. Daily Interest

Simple Annual Interest (less common):

Interest = Principal × Rate × Time

Compound Interest (most common):
- Interest on interest: Unpaid interest added to principal
- Compounded annually: Once per year
- Accelerates growth: Loan balance grows faster

Simple Interest Formula

Interest = Principal × Interest Rate × Time (in years)

Example:

Loan amount: $20,000
Interest rate: 6% per year
Time: 1 year

Interest = $20,000 × 0.06 × 1 = $1,200
Total owed after 1 year: $20,000 + $1,200 = $21,200

Compound Interest Formula

Future Value = Principal × (1 + Interest Rate)^Number of Years

Example:

Loan amount: $20,000
Interest rate: 6% per year (compounded annually)
Time: 5 years

Year 1: $20,000 × 1.06 = $21,200
Year 2: $21,200 × 1.06 = $22,472
Year 3: $22,472 × 1.06 = $23,820
Year 4: $23,820 × 1.06 = $25,249
Year 5: $25,249 × 1.06 = $26,764

OR using formula:
FV = $20,000 × (1.06)^5 = $20,000 × 1.338 = $26,760

Total interest: $26,760 - $20,000 = $6,760

Monthly Interest Calculation

Some policies calculate interest monthly:

Monthly Rate = Annual Rate ÷ 12
Monthly Interest = Loan Balance × Monthly Rate

Example:

Loan balance: $30,000
Annual rate: 6%
Monthly rate: 6% ÷ 12 = 0.5% = 0.005

Month 1 interest: $30,000 × 0.005 = $150
New balance: $30,150

Month 2 interest: $30,150 × 0.005 = $150.75
New balance: $30,300.75

What Is Capitalized Interest?

Unpaid interest added to loan principal:
- Not paid separately: Interest not paid out-of-pocket
- Added to loan: Increases loan balance
- Compounds: Future interest charged on increased balance
- Automatic: Happens automatically unless borrower pays interest

How It Works

1. Loan taken: Borrow $25,000 at 6%
2. Year 1 interest: $1,500 due
3. Not paid: Borrower doesn't pay interest
4. Capitalized: $1,500 added to loan balance
5. New balance: $26,500
6. Year 2 interest: $26,500 × 6% = $1,590
7. Continues: Process repeats each year

Long-term Impact

Capitalized interest accelerates loan growth:

Initial loan: $50,000
Interest rate: 6%
No payments made

Year 1: $53,000 (added $3,000 interest)
Year 5: $66,911
Year 10: $89,542
Year 15: $119,828
Year 20: $160,357

Policy Lapse Risk

Policy lapses when:

Loan Balance + Accrued Interest ≥ Cash Surrender Value

Example:

Cash value: $100,000
Loan balance: $95,000
Annual interest: 6% = $5,700

Without payment:
New loan balance: $100,700
Exceeds cash value: $100,000
Result: Policy may lapse (grace period given)

Impact of Outstanding Loans

When insured dies with outstanding loan:

Net Death Benefit = Face Amount - (Loan Principal + Accrued Interest)

Examples

Example 1: Recent Loan

Face amount: $250,000
Loan principal: $40,000
Accrued interest: $1,200

Total loan balance: $40,000 + $1,200 = $41,200
Net death benefit: $250,000 - $41,200 = $208,800

Beneficiary receives: $208,800

Example 2: Long-standing Loan

Face amount: $500,000
Original loan: $100,000 (taken 10 years ago)
Interest rate: 6% compounded annually
No payments made

Loan balance after 10 years: $100,000 × (1.06)^10 = $179,085

Net death benefit: $500,000 - $179,085 = $320,915

Beneficiary receives: $320,915

Example 3: Multiple Loans

Face amount: $300,000

Loan 1: $50,000 (taken 3 years ago at 5%)
Balance: $50,000 × (1.05)^3 = $57,881

Loan 2: $30,000 (taken 1 year ago at 6%)
Balance: $30,000 × 1.06 = $31,800

Total loan balance: $57,881 + $31,800 = $89,681

Net death benefit: $300,000 - $89,681 = $210,319

Universal Life Considerations

UL policies - two death benefit options:

Option A (Level Death Benefit)

Death Benefit = Face Amount
Less: Loan + Interest

Option B (Increasing Death Benefit)

Death Benefit = Face Amount + Cash Value
Less: Loan + Interest

Example:

Face amount: $250,000
Cash value: $60,000
Loan balance: $40,000

Option A: $250,000 - $40,000 = $210,000
Option B: ($250,000 + $60,000) - $40,000 = $270,000

Full Repayment

To pay off completely:

Amount Needed = Current Loan Balance + Current Accrued Interest

Example:

Loan taken: $50,000 (5 years ago)
Interest rate: 6%
Balance after 5 years: $66,911

To pay off completely: $66,911

Effect:
- Loan balance: $0
- Full death benefit restored
- Cash value no longer encumbered

Partial Repayment

Can repay any amount:

Options:
1. Pay interest only: Prevents loan from growing
2. Pay principal only: Reduces loan but interest still accrues on remaining
3. Pay both: Reduces both principal and future interest

Example:

Loan balance: $75,000
Annual interest: 6% = $4,500

Option 1 - Pay interest only ($4,500/year):
Loan stays at $75,000 (doesn't grow)

Option 2 - Pay $10,000 principal:
New balance: $65,000
Next year interest: $3,900

Option 3 - Pay $14,500 ($10,000 principal + $4,500 interest):
New balance: $65,000
No additional interest accrued

Policy Surrender with Outstanding Loan

Surrender value calculation:

Net Cash Surrender Value = Cash Surrender Value - Outstanding Loan Balance

Example:

Cash value: $100,000
Surrender charge: $5,000
Cash surrender value: $95,000
Loan balance: $60,000

Net received: $95,000 - $60,000 = $35,000

Tax Implications

Gains may be taxable:

Taxable Gain = (CSV + Loan Balance) - Total Premiums Paid

Example:

Cash surrender value: $80,000
Outstanding loan: $40,000
Total premiums paid: $50,000

Policy basis: $50,000
Policy value: $80,000 (CSV) + $40,000 (loan) = $120,000
Taxable gain: $120,000 - $50,000 = $70,000

If policy surrendered with loan:
Cash received: $40,000 (CSV minus loan)
Taxable gain: $70,000 (must pay tax on $70,000 even though only received $40,000!)

Automatic Premium Loan (APL)

Provision that automatically borrows premium if unpaid:

Loan Amount = Unpaid Premium

Example:

Annual premium: $3,600
Premium not paid
APL provision active
Cash value available: $50,000

Automatic loan: $3,600
New loan balance: $3,600
Policy remains in force
Interest begins accruing on $3,600

Example 1: Business Loan Collateral

Business owner needs $150,000
Policy cash value: $200,000
Loan percentage: 90%
Interest rate: 5%

Maximum available: $200,000 × 0.90 = $180,000
Actual loan: $150,000 (under maximum)

If held 3 years:
Loan balance: $150,000 × (1.05)^3 = $173,644

If owner dies:
Face amount: $500,000
Net benefit: $500,000 - $173,644 = $326,356

Example 2: Retirement Income

Retiree has policy:
Cash value: $300,000
Face amount: $500,000

Takes series of loans:
Year 1: $30,000
Year 2: $30,000
Year 3: $30,000

Interest rate: 6% (capitalized)

After 3 years:
Year 1 loan: $30,000 × (1.06)^3 = $35,730
Year 2 loan: $30,000 × (1.06)^2 = $33,708
Year 3 loan: $30,000 × (1.06)^1 = $31,800
Total balance: $101,238

Remaining death benefit: $500,000 - $101,238 = $398,762

Example 3: Lapse Prevention

Warning scenario:
Cash value: $120,000
Outstanding loan: $110,000
Interest rate: 6%
Annual interest: $110,000 × 0.06 = $6,600

If interest capitalizes:
New balance: $116,600
Cushion remaining: $120,000 - $116,600 = $3,400

Next year interest: $116,600 × 0.06 = $6,996
Would exceed cash value: $116,600 + $6,996 = $123,596 > $120,000

Action needed:
Pay at least annual interest ($6,600/year) to prevent lapse
Or make principal payment to reduce balance

• Maximum loan: 90-95% of cash surrender value (some 100%)
• No credit check required: Guaranteed right for policyowner
• Interest is charged: Typically 5-8% annually
• Capitalized interest: Unpaid interest added to loan balance (compounds)
• Reduces death benefit: Loan + interest deducted from death benefit
• No repayment required: Can repay anytime or never
• Policy can lapse: If loan + interest ≥ cash value
• Simple interest formula: Interest = Principal × Rate × Time
• Compound interest formula: FV = Principal × (1 + Rate)^Years
• Net death benefit: Face Amount - (Loan + Interest)
• Tax implications: Surrender with loan can trigger taxable gain
• Automatic premium loan (APL): Borrows premium if unpaid
• Partial repayment allowed: Can pay interest only, principal only, or both
• Direct recognition: Some policies credit different rate on loaned portion
• Not really a loan: Using your own money with insurer's lien