But What About the Life Insurance Loan Interest?

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Life insurance loan interest causes a lot of misunderstanding.  The interest is a charge assessed by the insurance company on any outstanding loan balance a policyholder has against an insurance policy's cash value.  That seems simple enough, but why does the insurance company charge interest?  How much interest do you have to pay on a policy loan?  When do you owe interest to the insurance company?  What are the tax benefits of loan interest?  If you take a loan against a life insurance policy, don't you have to pay the interest back?

Throughout my decade-plus time in the insurance industry, these above questions come up the most often.  I figured it would be helpful to address them and help shed some light on this subject that can cause so much confusion.

What is the Interest Rate on a Life Insurance Loan?

The loan interest charged on a life insurance policy loan depends on the specific policy contract.  Loan interest varies not only from insurance company to insurance company, but it can also vary from product to product within one insurer.  Normally the insurance contract will detail how the insurance company charges interest against a loan.  If the rate is a fixed-loan, this specific interest rate will appear in the insurance contract.

If, on the other hand, the insurance company uses a variable loan, the contract will instead provide detail on how the insurance company goes about setting the loan interest.  The contract will also provide details on how often the loan interest can change.

It's also possible for a life insurance policy to have multiple loan options available.  When I say options, I mean the way the loan works or the interest charged on the loan may differ.  As the policyholder, you'll have the option to choose which loan you want when taking a loan against your policy.  Some examples of different loans include fixed versus variable loan interest or indexed versus fixed loans on an indexed universal life policy.

You can also find information about loan interest applicable to your life insurance policy through the insurance companies customer service department.  This includes both specific information found through an online web portal that provides you with details about your policy as well as a call to the insurer's customer service department.

Do you Pay Interest on Life Insurance?

You only pay interest on a loan if one is outstanding against your policy's cash value.  There is no other interest charge you must pay on a life insurance policy.  You also only pay interest on a loan balance that is currently outstanding.  Life insurers will adjust the loan charge at every loan calculation period if you made a payment to the loan's balance.

For example, if the loan on your policy calculates interest on a daily basis (very common) and charges interest at the end of the policy year (also known as in arrears), then interest only accumulates on the policy balance as of that day.  So if you begin the month with a $10,000 loan balance, and then make a $500 payment to the loan on the first day of the month, the insurance company will only charge interest against a $9,500 balance moving forward.

It's also helpful to understand that all payments made to a life insurance loan during the year will pay down the balance of the loan.  You will only make interest payments (if you choose to) at the end of the policy year when the interest payment is due.  I say “if you choose to” because you can opt to let the interest add to the loan balance and simply continue making loan balance repayments.

The exact time that you owe the interest payment to the life insurance company is at the end of the policy year.  Some insurers will add the interest payment to the loan balance “in advance,” while others will add it “in arrears.”

Interest added in advance means the insurer will add the interest to the loan balance as soon as you request the loan and at the beginning of each policy year.  The insurer assumes, effectively, that you will not make any loan repayments throughout the policy year.  This practice of loan interest timing is more costly than the alternative “in arrears” option.

Interest added in arrears means the insurer will not add the interest charges against the loan until the end of the policy year.  Additionally, the insurer will modify the loan interest accumulating when you make payments to the loan because you are decreasing the loan balance.  This option will tend to cost you less in interest charges–though it's possible that a lower nominal interest rate use when adding interest in advance could come out better for you.

Can I Deduct Loan Interest Paid on a Life Insurance Loan

The answer is yes and no.  There is nothing specific in the Tax Code that permits deducting interest paid to a life insurer from your income.  However, there are areas of the tax code that permit deducting interest from income.

For example, interest paid by businesses for business activity is usually deductible.  If you own a small business and you own a life insurance policy, you may be able to use a policy loan to make a business purchase that allows you to deduct the interest payment on the loan from your income.

Additionally, the Tax Code does allow a tax deduction for loans used to acquire certain income-producing assets.  This deduction is available to non-business owners.  There are several rules surrounding this tax deduction, so you'll want to work with a qualified tax advisor to ensure that you are following the rules, but this is another way you could use life insurance loan interest as a tax deduction.

Do I have to Pay Back Loans on Life Insurance?

Technically loans do not have a specific repayment schedule, nor does loan interest.  The cash value in your policy serves as collateral for the loan, and the insurer is willing to lend to you so long as you have an outstanding cash surrender value.  Because you can add loan interest to the loan balance, the insurer will also never demand payment for the loan interest.

Unless…

If you run out of cash surrender value, you will either need to repay a portion of the loan balance or else surrender your life insurance policy.  The insurance company will not lend you more money than you have in cash surrender value.  It also won't let you accumulate an interest balance that when added to the loan balance will total a number larger than your cash surrender value.

You can, however, plan to die before your loan balance ever reaches a value equal to your cash surrender value.  People commonly do this when they choose to use life insurance for retirement income.  Under this arrangement, the policyholder begins taking loans against the life insurance policy, with the plan that he/she will die before creating a loan balance so large it equals the future cash value in the policy.  If death occurs while a loan remains outstanding against the policy, the insurance company simply deducts the loan balance from the death benefit.  The life insurer then pays the remaining death benefit amount to the beneficiary of the policy.

Does Loan Interest Make Life Insurance a Bad Deal?

Some people believe that the interest charged on a life insurance policy loan makes all cash value life insurance a bad deal.  While it's easy to see why some people might confuse the semantics and incorrectly paint life insurance with too broad a brush, you can overlook some very powerful wealth-building and income-producing opportunities if you default to thinking that all cash value life insurance is bad because of the interest due on loans.

Even after paying loan interest, the net benefit extracted from many life insurance policies can way out-pace other options you might have at your disposal.  The loan feature of life insurance can help produce significant income versus other assets people buy inside their 401(k)'s and IRA's.  So it's wise to spend some time looking at the bigger picture when it comes to life insurance because you might find that the many benefits it affords outweigh your apprehension due to labels put on various features.