Q&A: Policy loans are often misunderstood

A version of this question has been posed to me so many times, I’ve lost count.  Following is my answer.


How on earth do I have a policy loan when I’ve never taken any money out of my life insurance policy, let alone a loan?


I understand your confusion as it seems almost impossible.  When they’re introduced to me, many policy owners seriously believe there is an error on the part of the insurance company.

That being said, this is not uncommon.  I more often see loans on traditional whole life policies than I do other type of life insurance contracts.  This is because there are multiple possible dividend options available and most policy owners aren’t aware of the decisions made on their behalf.

In the high interest and policy dividend era of the 80s & 90s and even more recently, many whole life policies were sold on a “short pay” basis.  Sometimes these were called “vanishing premiums”.  What was not understood is that the premiums were always due per the contract, whether to age 65, age 90 or life, for example, whether or not the premiums were paid out of pocket.  The sales projections assumed enough build up of cash value that policy values would be able to pay or support the premiums rather than the policy owner cutting a check.  Many “10 pays” were simply a projection of how many premiums would be needed at the crediting and expenses assumptions in play at the point the policy was issued.  Even though the premiums weren’t shown to be paid out of packet after a certain number of years in the projections, they were still to be paid in some manner.  The fact that projections and guarantees are vastly different was lost on many.  In many situations the policy automatically took a loan from the insurance company for the premiums because that was the box that was checked on the original application.

It’s important to note that there are some actual limited pay whole life policies.  For example there are some true and guaranteed 10 pay or pay to 65 policies but they are in the minority.

If a policy owner thought she had a 10 pay contract and paid 10 premiums out of pocket and then stopped writing checks, the policy would stay in force because in the eleventh year the premium would be paid by a $10,000 policy loan from the insurance company.

10 years later, at an 8% loan interest rate (common even today, believe it or not) the policy would have a $156,455 loan.  In 20 years it would be roughly $500,000.  This comes as a huge surprise to many.

That’s why your policy has a loan.  That’s what was supposed to happen but you just didn’t understand it.  Maybe you were told and forgot or maybe you were never informed to begin with. Either way, you’re here now.

This is how the policies are “supposed” to work but the problem is that the dividend crediting rates of these policies have fallen precipitously over the years, more than 50% from their highs in many cases.  The original crediting assumptions could service this loan you didn’t know about but at today’s crediting rates this can’t always happen.  If the policy has a meaningful loan and the policy wasn’t funded suitably to withstand the reduced crediting, the loan may grow out of control and take over the policy.  This happens more often than you think.

In most situations the policy dividend option was long ago set to buy additional insurance, called paid up additions (PUAs), while the premiums were paid by loans.  In a declining interest rate market that should probably have been changed but many life insurance policies have little to no ongoing management.  Loan interest alone begins to outstrip the cash value growth of the policy and the PUAs are often surrendered to make ends meet.  Eventually they run out and the premium can no longer be borrowed and premiums need to be paid out of pocket again, along with loan interest.  It’s not uncommon to see mandatory out of pocket payments to the insurance company far in excess of, and maybe multiple times, the original premium the policy owner thought was guaranteed.

In the worst case situations the policy will lapse with all the cash value, death benefit and premiums lost.  However, it can be much worse and often is.  The loan is considered forgiven and this is taxed as ordinary income to the extent it exceeds basis in the policy.  Another way to look at it is to ignore the loan and focus on the gross cash value.  Gross cash value in excess of basis is taxable at ordinary income rates when the policy lapses.  The policy owner is looking at paying income taxes on phantom gain on a collapsing life insurance policy.

I’ve seen it happen and this is not fantasy or a scare tactic.  It’s a wake up notice.  Going back to your original question, if you don’t even realize your policy could have a loan without you taking money out, what’s the chance you understand the more intricate details of the contract and the potential consequences?

I realize I answered more than your original question but this is important enough to get in to.

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