A life insurance policy serves as a cornerstone of financial protection for your loved ones. Certain permanent life insurance policies, such as whole life and universal life, offer an additional benefit: a cash value component you can borrow against while you’re still alive. Taking a loan against your policy can be a quick and convenient way to access funds without a credit check.
But what happens if you don’t pay it back?
Many policyholders assume the worst—collections, credit score damage, or legal trouble. The reality is more nuanced but carries significant risks to your policy’s health and your financial future. This guide explains exactly what happens when a life insurance loan goes unpaid, the potential consequences, and the options available to you.
Understanding Life Insurance Loans: Not Traditional Debt
It’s crucial to understand that a life insurance loan is fundamentally different from a bank or personal loan. You are not borrowing money from an outside lender; you are borrowing from the insurance company using your policy’s cash value as collateral.
Because you are essentially borrowing your own money, the immediate consequences are less severe than with traditional debt:
No Credit Impact: The loan will not be reported to credit bureaus, so it will not affect your credit score.
No Collections: The insurance company will not send collections agencies after you or demand repayment. Repayment is flexible, and you can often set your own schedule.
No Legal Action: The insurer cannot sue you to recover the funds.
While you are not obligated to repay the loan with outside money, choosing not to pay it back is not without serious consequences.
The Real Consequences of an Unpaid Life Insurance Loan
The impact of an unpaid loan centers on your policy’s value and the benefits your heirs will eventually receive.
1. Your Death Benefit Will Be Reduced
This is the most direct and certain consequence. If you pass away with an outstanding loan, the insurance company will deduct the total loan balance—including all accrued interest—from the death benefit before paying the remainder to your beneficiaries.
Example: You have a $500,000 life insurance policy and an outstanding loan of $50,000 (including interest). If you die, your beneficiaries will receive $450,000, not the full $500,000.
This reduction can significantly undermine the financial security you intended to provide for your loved ones.
2. Your Policy Could Lapse and Coverage Could Terminate
This is the greatest risk of an unpaid loan. A life insurance loan accrues interest over time, just like any other loan. If you don’t make interest payments, the interest is typically added to the loan principal, causing the balance to compound and grow.
If the total loan balance (principal plus all accrued interest) grows to exceed the policy’s cash value, the policy will lapse.
What is a lapsed policy? A lapsed policy is one that has been terminated due to non-payment (of premiums or, in this case, because the loan has depleted its value). When a policy lapses, your life insurance coverage ceases completely. Your beneficiaries will receive nothing when you die.
The Danger Zone: This risk is especially high with Universal Life (UL) policies, which have flexible premiums and are more sensitive to market performance and rising insurance costs. As the loan grows, it can “eat its own cash value,” eventually leaving the policy underfunded and causing it to terminate.
3. You Could Face a “Tax Bomb”
Perhaps the most dangerous and least understood risk of an unpaid loan is the potential for a massive, unexpected tax bill—often called a “tax bomb.”
Here’s how it happens:
Gains Are Taxable Upon Lapse: When a life insurance policy is surrendered or lapses, any gain is taxed as ordinary income. The gain is calculated as the policy’s cash value minus your cost basis (the total premiums you’ve paid).
The Loan Doesn’t Erase the Gain: Even if the entire cash value is used to repay the loan at the time of lapse, the IRS still calculates the taxable gain based on the cash value before the loan was repaid.
The Tax Bomb Scenario: You could have a policy with a large loan that lapses with $0 in net cash value paid to you. However, if the policy had a gain, you will receive a Form 1099-R and owe income tax on that “phantom income”—money you never physically received because it went to pay off the loan.
Example: Your policy has a $105,000 cash value and a $60,000 cost basis (premiums paid). You have a loan of $100,000. The policy is about to lapse. The insurer uses the $105,000 cash value to repay the $100,000 loan, and you receive a check for the remaining $5,000. However, your taxable gain is still $45,000 ($105,000 cash value – $60,000 basis). At a 25% tax rate, you would owe $11,250 in taxes, more than double the cash you actually received.
This situation can leave you with a significant tax liability and no funds from the policy to pay it.
Your Options for an Outstanding Loan
If you have an unpaid life insurance loan, don’t ignore it. Be proactive and consider these options:
1. Request an In-Force Illustration
This is your most important first step. Contact your insurance company or agent and ask for a current in-force illustration. This document will project your policy’s future performance based on the current loan, showing you if and when it is projected to lapse.
2. Create a Repayment Plan
If you want to preserve the full death benefit, the best option is to repay the loan with interest. You can usually make payments on a flexible schedule.
3. Use Policy Dividends to Pay the Loan
If you have a participating whole life policy that pays dividends, you may be able to direct the dividends toward paying the loan interest or principal, which can help keep the policy from becoming “over-loaned.”
4. Surrender (Cancel) the Policy
You can choose to surrender the policy. The insurer will use the cash value to pay off the loan, and you will receive any remaining balance. Be aware of the potential tax consequences before making this decision.
5. Let the Policy Lapse
This is the riskiest option due to the potential tax bomb. If you do nothing and the loan grows larger than the cash value, the policy will terminate, your coverage will end, and you could still face a tax bill.
Take Control of Your Policy
An unpaid life insurance loan doesn’t have to become a financial disaster. The key is to be proactive and informed.
Communicate with Your Insurer: Document all communications in writing and don’t hesitate to escalate issues up the chain of command if you aren’t getting clear answers.
Understand Your Policy: Review your policy documents to understand its specific rules regarding loans and lapses.
Consult a Professional: If you’re unsure how to proceed, speak with a qualified financial advisor or your life insurance agent to review your options and avoid costly mistakes.
By understanding the rules and risks, you can make an informed decision that best protects your financial interests and the security of your loved ones.