Wash Loans… Really?

April 21, 2025

The Illusion of Equal Rates! Why the Crediting Rate Isn’t What It Seems: The Hidden Fees

It’s important to know how policy loans really work.

By Bill Boersma

Every once in a while, you reflect on something and realize, why do people think this? This most recently happened when I was working with a client who was being sold on a life insurance contract where the agent was touting a wash loan.

What Is a Wash Loan?

As a review, a wash loan is a reference to when the policy loan rate is the same as the policy crediting rate. Before we get into this, there’s a basic point that needs to be understood. When a policy owner takes a policy loan, they aren’t actually taking a loan from their policy or from themself, as it is generally marketed/postured. Rather, they’re actually taking a loan against their policy. This is a significant misunderstanding. They aren’t borrowing from themselves; they are borrowing from the insurance company, and the insurance company is collateralizing the loan with the policy cash value. You might think this is a matter of semantics, but it’s important to use the appropriate language to minimize the chance of misunderstanding.

It’s not uncommon to run across policies with loans on them at 8%, though this issue is important regardless of the loan rate. I think it’s critical that those policy owners know they are being charged an 8% loan rate, especially if the prevailing market loan rates are much lower, as they were for many recent years. For a typical (non-wash) loan, after the crediting on the cash value that collateralizes the loan is applied, there’s a spread. Let’s say the policy crediting is 7%, this makes the loan look like it’s only costing 1%. In a way it is, but in a way it’s not at all. The loan is actually growing at 8%, not 1%, and this makes a meaningful, and possibly dramatic difference.

The Numbers

If you had a whole life policy with an automatic premium loan that kicked in after you stopped paying premium out of pocket because dividends were supposed to cover it, these loans accumulate and grow over time. Let’s say you purchased the policy at age 35 with a $20,000 annual premium. You paid premium for 10 years and stopped and the automatic premium loan (APL) kicked in. First of all, most people don’t realize the premium is still being paid, just not by them out of pocket. They might be able to parrot the right words, but they effectively have no idea what it means.

Twenty grand a year for the next thirty years with interest is roughly $2,500,000. That’s a real two and a half million-dollar loan. At 1% it would have been only $700,000. That’s $100,000 of interest versus $1,900,000 of interest! Now you see why semantics matter? That’s a huge difference that is manifested when the accumulating loan is no longer supportable by the significantly reduced dividend rates and the policy starts to collapse. When it does, and the policy owner can’t manage to resume the annual premium and/or can’t make the $200,000 annual loan interest, the policy lapses, and the loan in excess of policy basis is taxed as ordinary income. That’s a taxable amount of almost $2 million at the top rates.

Now let’s say the policy is supportable for a while longer and the inflection point doesn’t come until age 90. Now you have an $8.35 million loan on a policy with a $1.1 million basis with no net cash value. Someone is looking at phantom gain of $7.25 million at the highest ordinary income tax rates. This isn’t hypothetical. I’m dealing with a similar situation right now.

Why It Matters

Let’s go back to the so-called wash loan. The policy in question was a mutual whole life policy with 6% dividend crediting and 6% loan interest rate. Seems simple enough. Would it surprise you that 6% doesn’t equal 6%? The 6% loan interest is as real as the day is long. I can go to the policy ledger and duplicate the numbers on my calculator. But the 6% crediting isn’t real. It’s a gross number that has numerous fees and costs deducted.

Need proof? Look at the policy cash value in year 10 of the contract. It’s not even equal to the cumulative premiums yet. There’s a negative rate of return on premium to cash value. The point is, what does 6% mean when it’s resulting in a loss over a decade? There are policy expenses, commissions, mortality charges, premium taxes, etc taken out. Over the very long haul there might be a three point something IRR, but… the 6% loan has been steadily accumulating. In this instance the agent was selling the deal as a retirement income transaction and illustrating income from the policy through loans. The story was that this was effectively free since the 6% loan rate was being offset by the 6% crediting. But this isn’t even close to the truth. It’s a misrepresentation, a fabrication, a lie, whatever you want to call it.

Depending on how the policy was managed, the loan may slowly eclipse everything else and eat up the policy from the inside and sets up the policy owner for the insidious tax time bomb referenced above.

This is like going to a bank or financial advisor and they tell you that there’s an investment that will yield 5% that will offset your line of credit that charges 5%, but… they fail to tell you about the 100-basis point management fee on the investments. That’s an important piece of the equation. It changes the numbers.

One More Way to Look at It

To prove that you’re not borrowing from yourself, think about this. If you had a savings account at the same bank where you have a line of credit, would you claim that borrowing from the line of credit is the same as borrowing from yourself? Of course not! You know you are borrowing from the bank, and your savings account is collateralizing the loan. If you’re earning 5% on your account and paying 5.50% on the line of credit, do you tell yourself the line of credit is only costing you 50 basis points? Of course not!

I’m not saying you shouldn’t ever take a loan on a policy, just know what you’re doing. Again, this isn’t hypothetical. I’ve seen people literally bankrupted by the tax on the gain of a failing life insurance policy when they misunderstood how it worked. Countless more have lost their policies and death benefit.

Why? For many of them, it’s because they were mislead about how policy loans work, as the information was misrepresented. I must admit that it can be quite challenging to help them unlearn their misunderstandings. When you absolutely believe something to be true, it can take a lot to get you to see the light. I mean, we all know this is how it works and now you, Bill, are coming in to tell me it’s not so. Come on!

Here’s one more take on it. Wash loans are often made out to be something fantastic. It’s like free money, a 0% loan. If I hypothetically assumed the policy crediting and loan rate where the same, which they are not, as discussed above, where did it ever start that this was a good deal? Ok, Bill, why isn’t it? Because you’re no longer making the money that you were prior to taking out the loan. Before, you were earning money, and the policy cash value and death benefit was growing. Even if the crediting and expense was equal, netting 0%, that’s not a free loan, that’s a loan equal to whatever your crediting was before the loan. In other words, if now you’re not getting what you were getting before, that’s your cost.

If you created a balance sheet with typical assets and liabilities, the net equity number will be different if there is a loan versus if there isn’t a loan. It’s going to change the numbers. Life insurance isn’t any different. And if you created an income statement, you’ll see the same thing.