Taking a loan from a life insurance policy can look like a convenient, low-hassle source of cash. The money is fast, there’s no credit check and repayment is flexible. But that same flexibility hides real risks.

If interest snowballs or the policy lapses, the consequences can damage both long-term protection and overall financial health.

Policy Loan Basics

A policy loan lets the owner of a permanent life insurance policy borrow against the policy’s cash value. This option exists only on policies that build cash value over time, such as whole life and universal life contracts. Term life coverage, which is designed to provide protection for a set period only, does not accumulate cash value and therefore cannot be used as collateral for a policy loan. Deciding between term and permanent insurance often comes down partly to whether access to cash value is genuinely needed.

How Policy Loans Work

When a policy loan is taken, the insurer does not literally hand over part of the cash value. Instead, it lends money from its general fund and records the policy’s cash value as security for that loan. The cash value usually continues to earn interest or dividends as if no loan had occurred.

Jason Silverberg, a certified financial planner, states, “Life insurance cash values can be accessed during the policy owner’s lifetime through two ways—loans and withdrawals.”

At the same time, the insurer charges interest on the borrowed amount, which may be fixed or variable depending on the contract. There is typically no required repayment schedule; the loan can be repaid on any timetable, or not at all during the policyholder’s lifetime. However, unpaid interest is added to the loan balance, and that growing balance becomes crucial over time.

If the total loan plus accumulated interest ever exceeds the available cash value, the policy can lapse. This often happens when interest compounds for years while the cash value growth is too small to keep pace. When a lapse occurs, coverage stops and the outstanding loan may be treated as taxable income, which can create an unexpected bill.

Insurer Requirements

Insurance companies set their own limits on when policy loans are allowed. Most require that the policy has been in force for several years and has reached a minimum cash value before borrowing is permitted.

Policies may also cap the amount that can be borrowed, often at 80% to 90% of cash value, leaving a buffer to help prevent immediate lapse. Exact thresholds and interest terms are spelled out in the contract or can be confirmed with the insurer or agent. Understanding these rules in advance helps avoid assuming access to funds that may not yet be available.

Key Advantages

Despite the risks, policy loans do have genuine strengths. Approval is fast, since there is no credit check or underwriting; the insurer already holds the collateral. Funds can arrive in days rather than weeks, making policy loans attractive in time-sensitive situations.

Because there is no credit inquiry, the loan does not affect a credit score. Interest rates are often lower than those on unsecured personal loans or revolving credit, and there is no restriction on how the funds are used. As long as the policy stays in force and does not lapse, the borrowed amount is generally not treated as taxable income. In some situations, interest on the loan may even be deductible, depending on how the funds are used and current tax rules.

Serious Drawbacks

Every dollar borrowed reduces the amount ultimately available to beneficiaries. If the loan is still outstanding at death, the insurer simply subtracts the balance plus interest from the death benefit before paying beneficiaries. This can significantly shrink the payout families may be depending on.

The bigger danger lies in compounding interest. Without a structured repayment schedule, it is easy to ignore the loan and let interest capitalize year after year. If the balance overtakes the cash value, the policy lapses. A lapse often leads to a tax bill on the outstanding loan amount, because it is now viewed as a distribution rather than a loan. At the same time, loved ones lose coverage entirely. That “easy” loan can turn into both a tax problem and a protection gap.

When Loans Can Fit

There are situations where a policy loan can be a rational tool. One example is a short-term cash need while waiting for another known source of funds, such as a pending settlement or property sale. If repayment will occur quickly, the impact on the policy can be minimal.

Policy loans may also make more sense later in life if dependents are financially independent and no longer rely on the full death benefit for basic needs. In that case, using a portion of cash value for a specific purpose might align with overall goals. For some people, a policy loan can be preferable to high-interest debt, provided there is a clear plan to repay both principal and accumulating interest. The key is treating it as a structured obligation, not casual spending money.

Smart Pre-Loan Steps

Before borrowing, one useful tool is an in-force policy illustration from the insurer—a carrier-generated projection of how the policy may perform over time under different loan and repayment assumptions. It can show how long the policy may sustain the loan and how the death benefit may change over time.

It is equally important to compare alternatives. A personal loan, a home equity line, or temporarily reducing discretionary spending may meet the cash need with less risk to long-term coverage. Some policies also allow partial withdrawals or using cash value to pay premiums for a time, which may reduce pressure without creating a compounding loan balance.

Final Thoughts

Policy loans are neither purely dangerous nor purely harmless. They can help in the right circumstances, but they can quietly erode coverage and trigger taxes if used carelessly.

Understanding how interest grows, how lapses occur, and how benefits for loved ones are affected is essential before borrowing. With that knowledge, a policy loan can be weighed alongside other funding options instead of becoming the automatic first choice.