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How Cash Value Works, and What a Policy Loan Really Costs

Where the money comes from, how borrowing against it works, and the trap at the end

If someone has told you there is money inside your life insurance policy, that may well be true, and getting at it is less simple than it sounds. Cash value is not a savings account with a policy attached. It is a feature of the contract, with rules about what you can take, what it costs and what it does to the coverage. This guide sets out the mechanics so the conversation with the insurer makes sense.

Which policies have it, and where it comes from

Cash value belongs to permanent insurance: whole life, universal life, variable universal life, indexed universal life, and most small final expense plans. Term insurance is built to have none, so if the policy covers a set number of years, there is generally nothing inside it to draw on.

The money accumulates from the part of each premium left after the insurer takes the cost of insuring the life and its expenses. What happens to that remainder depends on the type. Whole life builds guaranteed value on a schedule set out in the contract, and a participating policy may also receive dividends, which are not guaranteed and are declared each year. Universal life credits interest to an account value. Variable and indexed versions tie growth to investment performance or to an index, within limits the contract sets.

Three numbers that are not the same

Statements often show several figures and people read the wrong one.

• Cash value. The accumulated value inside the policy as the insurer accounts for it.
• Cash surrender value. What you would actually receive if you ended the policy today. In early years this can be lower than the cash value because of surrender charges, and any outstanding loan is deducted.
• Death benefit. What the contract is built to pay on the death of the insured. Loans, withdrawals and unpaid interest generally reduce it.

When you ask the insurer for figures, ask for all three, in writing, dated.

What a policy loan actually is

A policy loan is borrowing from the insurer with the policy as collateral. That matters, because it is not a withdrawal of your own money. The cash value stays in place, secures the loan and normally continues to be credited, while the loan accrues interest against you.

There is no credit check, no repayment schedule in most contracts, and no need to explain what the money is for. That flexibility is why loans get used, and it is where the trouble starts, because a loan with no repayment schedule tends not to get repaid.

The interest rate is set by the contract. Some policies use a fixed rate and some use a variable rate tied to an index, and some older contracts contain rates written when conditions were very different. Whichever applies, if the interest is not paid it is added to the loan, and the larger loan then accrues interest of its own. Meanwhile any loan outstanding when the insured dies is generally taken out of what the policy pays.

The part that catches people

The loan grows while the cash value securing it may not grow as fast. If the loan and its accrued interest come to exceed the value available, the insurer will ask for payment to keep the policy standing, and if that payment is not made the policy can terminate.

If a policy with a large loan terminates, the tax rules can treat the gain in the policy as income received, even though no money arrives at that moment. The cash was spent years earlier and the tax consequence lands at the end. Whether it applies to you depends on how much has been paid in and on how the policy is classified for tax purposes. That is a question for a tax professional, and better asked before the borrowing than after.

Other ways money comes out

• Withdrawal or partial surrender. Available on many universal life policies. It takes value out permanently and usually reduces the death benefit.
• Dividends. On a participating policy these can be taken in cash, used to reduce premiums, left to accumulate, or used to buy additional paid-up coverage.
• Reduced paid-up coverage. Where a contract offers it, premiums stop and a smaller amount of coverage continues. This ends the payments without ending all the coverage.
• Full surrender. Ending the contract for its surrender value. The coverage stops, and any gain over what was paid in is generally taxable.

Where people get this wrong

• Calling it their own money. A loan is a debt against the policy that carries interest and reduces what the policy pays while it is outstanding.
• Ignoring the interest notices. Unpaid loan interest is added to the balance, which is how a small loan becomes a large one without anyone borrowing again.
• Reading an old illustration as a promise. A projection made at the point of sale rested on assumptions. What matters now is a current in-force illustration on today's figures.
• Surrendering as a first move. Ending a policy is permanent, and there are often intermediate options in the contract. Price them before choosing the final one.
• Leaving the tax question until afterwards. Loans, withdrawals and surrenders each have different tax treatment, and the time to find out is before the paperwork is signed.

Questions people ask