Policy Loans on Universal Life Insurance: What Borrowing Really Costs

The Basics: How Policy Loans on Universal Life Actually Work

If you've built up cash value inside a universal life policy, you have something most people don't know they're sitting on — a line of credit you can tap at any time, for any reason, without a credit check or bank approval. Here's the mechanical reality of how it works.

When you request a policy loan, your insurance company doesn't technically reach into your cash value account and hand you money. Instead, the insurer lends you its own funds and uses your policy's accumulated cash value as collateral. Your account value stays on the books — meaning it can keep earning credited interest — but the insurer places a lien against it equal to the outstanding loan balance.

That distinction matters because of how interest is calculated on both sides of the ledger. You owe the insurer loan interest (set in your policy contract, typically somewhere between 5% and 8% annually). Meanwhile, the cash value that serves as collateral may still earn a credited rate — either the same rate as before (called a participating or wash loan) or a lower rate while the loan is outstanding (a non-participating loan). The net cost of borrowing depends heavily on which type your policy uses.

One more foundational point: you don't need to tell the insurer what you're doing with the money. Pay off medical bills, cover a home repair, fund a business — the loan is yours to use however you see fit. And there's no monthly statement showing a minimum payment due. That freedom, though, cuts both ways.

To understand where the cash value comes from in the first place, see our explanation of how cash value accumulates in universal life policies.

What a Policy Loan Actually Costs You

"No credit check, no repayment schedule" sounds too good to be true. In one sense it is — you're not getting free money. You're getting a deferred cost that grows quietly in the background while you go about your life.

Here's where the real cost lives: compounding loan interest. If your policy charges 6% annual loan interest and you borrow $40,000 without making any payments, you'll owe about $53,600 after five years — and roughly $71,600 after ten. Every dollar of that interest gets added to your loan balance, which in turn generates more interest the following year.

Meanwhile, your policy's cost of insurance charges continue to deduct from the cash value each month. These charges rise as you get older. If you're in your 60s or 70s and carrying a large loan balance, the combination of rising insurance costs and compounding loan interest can consume your cash value faster than most people anticipate. That's how policies lapse on people who thought they were doing fine.

The most accurate way to gauge the true cost of a policy loan is to ask your insurer for an in-force illustration that models the loan outstanding with no repayments. This shows projected cash value and death benefit over time, and whether the policy is on a path toward lapse. Request one annually if you're carrying a balance.

For a deeper look at what else is eating into your cash value alongside loan interest, see our guide on cost of insurance charges in universal life.

The Lapse Risk: The Scenario Most Borrowers Don't See Coming

This is the conversation your insurance agent may not have had with you when you signed the policy. And it's the one that matters most.

A universal life policy lapses when the cash value can no longer cover the charges due — the cost of insurance deductions, administrative fees, and, crucially, accrued loan interest. When that happens, the insurer will send you a lapse notice and give you a grace period (usually 30 to 60 days) to either pay enough into the policy to keep it alive or pay down the outstanding loan.

If you do nothing, the policy terminates. And here's where the tax hit arrives: the IRS treats a lapsed policy with an outstanding loan as a taxable distribution. Specifically, whatever gain existed in the policy — the amount by which the cash value exceeded your total premiums paid — becomes ordinary income in the year the policy lapses. If you had $80,000 in accumulated gain and the policy lapses with a $60,000 outstanding loan, you could owe income tax on a large chunk of that gain, even though you received no cash at lapse.

This outcome blindsides people because they went years making no loan payments, the policy seemed fine, and then suddenly there's a tax bill with no cash to pay it. The antidote is staying engaged: review your annual statement, request in-force illustrations, and take the lapse warning notices seriously if they arrive.

If your policy does receive a lapse notice, contact your insurer immediately. Many companies will work with you on a reduced paid-up option or a policy restructuring that avoids a taxable event — but only if you act within the grace period.

Policy Loans vs. Partial Withdrawals: Choosing the Right Tool

When you need money from your UL policy, you generally have two options: take a loan or take a partial withdrawal. They're not the same thing, and the one you pick affects both your death benefit and your taxes.

As a general rule of thumb: if you expect to repay the funds eventually, a loan keeps the policy structure intact and has a clean tax profile as long as the policy stays in force. If you need a smaller, one-time access to funds and your basis covers the amount, a withdrawal can be simpler with no interest cost.

The tax angle on both options is nuanced enough that it's worth reviewing carefully. Our article on the tax treatment of universal life cash value walks through both scenarios in detail.

How This Compares to Borrowing From a Whole Life Policy

Universal life and whole life both allow policy loans, and from the outside they look identical. But the mechanics underneath are meaningfully different — and those differences affect how risky it is to carry an unpaid loan long-term.

Whole life policies have guaranteed cash value growth and guaranteed level premiums. The cost of insurance is baked into a fixed premium that doesn't change, so there's no mechanism by which rising insurance costs accelerate toward a lapse. The cash value grows on a predictable schedule regardless of what interest rates do.

Universal life is more flexible but also more exposed. UL policies credit interest based on current rates (or market performance in index or variable versions), and cost of insurance charges can rise with age. A loan that looks manageable at 55 can become a serious problem by 70 if interest rates on the credited side have dropped and insurance costs have risen. The flexibility that makes UL appealing is the same flexibility that makes the lapse risk real.

That said, for people who fund their UL policy well above the minimum premium and borrow conservatively, the loan feature works smoothly. The danger is specifically in underfunded policies with large outstanding loans.

If you're comparing the two policy types for borrowing purposes, our detailed piece on how policy loans work on whole life insurance covers the whole life side of that comparison.

“The danger of policy loans isn't the borrowing — it's the forgetting. The loan sits there, interest compounds, insurance costs rise, and policyholders are shocked when a policy they assumed was fine sends them a tax bill instead of a death benefit.”

— Michael Finke, Professor of Wealth Management, The American College of Financial Services

Strategies to Borrow Smarter and Protect Your Policy

If you're going to use a policy loan — and plenty of people do so successfully — there are ways to do it that dramatically reduce the risks described above.

Pay the interest annually, at minimum

You don't have to repay principal. But paying the annual interest charge each year prevents compounding and keeps your loan balance from growing. On a $50,000 loan at 6%, that's $3,000 a year — meaningful, but far less painful than watching the balance balloon to $90,000 over a decade.

Request an in-force illustration before and after borrowing

Before you pull the trigger on a loan, ask your insurer to run a current illustration showing what happens to your policy under different scenarios — including one with the loan outstanding and zero repayments. This tells you exactly how many years of runway you have before the policy is in trouble.

Maintain premium payments above the minimum

UL policies let you pay flexible premiums, but paying just enough to keep the policy alive leaves no cushion. If you're carrying a loan, paying above the minimum premium helps maintain cash value and offsets the drag of loan interest. Overfunding your UL policy before you need to borrow is one of the smartest moves you can make.

Set a personal repayment timeline

Just because repayment isn't required doesn't mean it's a bad idea. Treating the loan like a 5-year self-imposed obligation — even with irregular payments — keeps the balance in check and preserves your death benefit for your beneficiaries.

If you're in a higher income tax bracket, the tax-free nature of a UL policy loan becomes even more valuable compared to taking a taxable distribution from a retirement account. Run the numbers with a financial advisor before assuming which source of funds is cheaper.

The Bottom Line: Flexibility Is Real, But So Is the Risk

Universal life insurance's loan feature is genuinely useful. It's one of the more flexible financial tools available — you get liquidity without a lender, without taxes (as long as the policy stays alive), and without a repayment deadline. For someone navigating a temporary cash crunch, funding a business opportunity, or bridging a gap in retirement income, a UL policy loan can be exactly the right move.

But "flexible" doesn't mean "free." The costs are real — they're just delayed, compounding, and easy to ignore until a crisis hits. A policy loan that seemed manageable at 58 can become a policy-threatening liability at 72 if it's never touched again. The people who get burned aren't reckless — they're people who simply stopped paying attention.

The playbook is simple: borrow thoughtfully, pay the interest at minimum, run an in-force illustration every year, and treat the lapse warning notices like the financial emergency they are. Do those things, and the loan feature is a genuine advantage. Ignore them, and you risk losing both the death benefit your family was counting on and a surprise tax bill on top of it.

For a broader orientation on how universal life compares to simpler alternatives, you can also explore how term life insurance works and how whole life coverage compares.