Can You Borrow From Universal Life Insurance? Limits, Costs, Taxes

You can borrow from a universal life insurance policy once it has built enough cash value, and most insurers will lend you up to about 90% of that value without a credit check, income verification, or fixed repayment deadline. Interest rates generally run between 5% and 8%.¹ The money comes fast and the terms are forgiving, but the loan quietly reduces your death benefit, can trigger a surprise tax bill if the policy lapses, and in a few situations is taxable from day one. Before you borrow, you need to understand each of those trade-offs.

How Much You Can Borrow

Universal life splits every premium between the cost of insurance and a cash account that earns interest. That cash account takes time to grow. Surrender charges absorb much of it in the early years, so most policies won’t have meaningful borrowable value until at least the second or third year.² How fast it builds after that depends on how much you pay above the minimum premium and the crediting rate your insurer applies.

The borrowable figure is the net surrender value: your cash account minus any remaining surrender charges. Insurers typically cap loans at about 90% of that net amount, leaving a cushion to keep the policy funded while the loan is outstanding.³ If your cash value hasn’t crossed the insurer’s minimum threshold, the request gets denied. Pull your latest statement before applying so you know what you have to work with.

What the Loan Will Cost You

When you borrow, the insurer pays you from its own general account and uses your cash value as collateral. The cash value itself doesn’t leave the policy; it keeps earning interest, though often at a different rate than the unloaned portion. The insurer then charges you interest on the loan balance, typically 5% to 8% per year.¹

Policies carry either a fixed or variable loan rate. The NAIC Model Policy Loan Interest Rate Bill, which most states have adopted in some form, caps fixed rates at 8% and ties variable rates to the Moody’s Corporate Bond Yield Average.⁴ State maximums generally fall between 8% and 10%.

Direct Recognition and Wash Loans

How your cash value grows while the loan is outstanding depends on your insurer’s recognition method. Under direct recognition, the insurer adjusts the crediting rate on the collateralized portion of your cash value; that adjustment can run higher or lower than the normal rate. Under non-direct recognition, the entire cash value earns the same rate regardless of any outstanding loan. Neither method is automatically better, because non-direct-recognition insurers often make up the difference in the loan rate itself.

Some universal life contracts offer a “wash” or “zero-net-cost” loan, where the interest charged on the loan equals the interest credited to the collateralized cash value, making the net borrowing cost effectively zero.⁵ These provisions usually kick in only after the policy has been in force for a set number of years, often ten or more. If this feature matters to you, check the contract for it before you borrow.

Repayment Is Flexible, and That’s the Problem

Policy loans have no mandatory repayment schedule. You can pay back a lump sum one month, nothing the next, or never repay at all.⁶ That is the main appeal and also the main trap. Without a payment structure, borrowers tend to ignore the balance while interest keeps compounding.

Payments go to the insurer directly and are credited first to accrued interest, then to principal. If you want the discipline of a conventional loan without the contractual obligation, set up automatic monthly or quarterly payments. For short-term liquidity you intend to repay within a year or two, the interest cost stays reasonable. For open-ended borrowing with no plan, model the long-term effect on your cash value and death benefit before you sign.

What a Loan Does to Your Death Benefit

Any outstanding loan balance, plus accrued interest, is subtracted from the death benefit before your beneficiaries get paid. On a $500,000 policy with $50,000 owed and $2,000 of accrued interest at the time of death, the insurer pays out $448,000. The deduction happens automatically during the claims process.³

A single, managed loan isn’t the danger. The damage comes from loans that sit for years while interest compounds. Borrow $100,000 at 6% and make no payments, and after five years you owe roughly $134,000. The death benefit shrinks in step. If you want to preserve the full payout for your family, cover at least the annual interest so the balance doesn’t balloon.

How the Loan Is Taxed

Under federal tax law, loans from a standard (non-MEC) life insurance policy are not treated as taxable distributions. The Internal Revenue Code specifically exempts life insurance contracts from the rule that would otherwise count policy loans as income.⁷ No 1099, no reporting on your return, no change to your bracket — as long as the policy stays in force.

That protection vanishes the moment the policy terminates with a loan still owed, which is covered below.

Modified Endowment Contracts Change the Rules

A universal life policy loses its favorable loan treatment if it becomes a Modified Endowment Contract (MEC). That happens when cumulative premiums during the first seven years exceed the IRS “7-pay test” limit, roughly the amount needed to pay up the policy in seven level annual installments.⁸ Overfunding a policy to accelerate cash value growth is the most common way to trip the threshold.

Once the policy is a MEC, every loan is treated as a taxable distribution with gains coming out first. You pay ordinary income tax on the portion of the loan representing earnings above your premium basis. If you’re under 59½, an additional 10% penalty tax applies.⁹ MEC status is permanent and cannot be reversed. If you’ve been paying premiums above the scheduled amount, ask your insurer to confirm you aren’t approaching the 7-pay limit.

Policy Lapse and Phantom Income

A universal life policy lapses when the cash value drops to zero and premium payments can’t cover the policy’s internal charges. An outstanding loan accelerates that risk: interest keeps accruing, cost of insurance keeps coming out, and administrative fees keep hitting. When the cash value can’t cover those charges, the insurer sends a notice giving you a window, usually 30 to 60 days, to make a payment. Miss it and the policy terminates.

Here is the part that catches people off guard. When a policy with an outstanding loan lapses, the IRS treats the full cash value as a distribution. The taxable amount is the policy’s total value minus your cost basis (generally the premiums you’ve paid). Because the loan went to repay the insurer, you can end up owing income tax on money that never hit your bank account. The industry calls this phantom income. If you paid $80,000 in premiums and the cash value at lapse was $100,000, all of which went to pay off your loan, you owe ordinary income tax on the $20,000 gain.⁷

Watch the ratio of your outstanding loan to your remaining cash value. If it climbs above 80% or 90%, make a payment, boost your premium deposits, or talk to the insurer about restructuring before the math becomes irreversible.

Loan or Partial Withdrawal?

Universal life policies also allow partial withdrawals, sometimes called partial surrenders, and they behave differently from loans. A withdrawal permanently reduces your cash value and typically reduces the death benefit by a corresponding amount. There is nothing to repay; the money is simply removed from the policy.

For a non-MEC policy, partial withdrawals come out of your cost basis first. You can withdraw up to the total premiums you’ve paid without owing tax, and only amounts above that basis trigger income tax.⁶ A loan, by contrast, doesn’t touch your basis at all while the policy stays in force. The trade-off runs in both directions. A withdrawal accrues no interest but permanently shrinks the policy. A loan preserves the death benefit if repaid but carries interest and lapse risk.

Inside a MEC, both options follow the same unfavorable rules: gains out first, taxed as ordinary income, with the 10% penalty under 59½. The distinction largely disappears.

How to Request a Policy Loan

The mechanics are straightforward. Most insurers provide a loan request form through their online portal. You supply your policy number, the dollar amount, and how you want the funds (usually electronic transfer or paper check), along with identity and address verification. For an electronic transfer, you’ll need your bank’s routing and account numbers. Paper checks take longer, sometimes ten business days or more. Online submissions with electronic signatures move fastest, though many insurers still accept faxed or mailed forms.

Processing varies. Some insurers fund within a week; others take two to three weeks from application to disbursement.³ The insurer verifies your net surrender value and the request’s compliance with the contract. If anything is off, a representative will call before funds release. Confirming your available cash value against your latest statement before you file keeps the process from stalling.

1
New York Life Insurance Company. Borrowing Against Life Insurance
2
Guardian Life Insurance of America. Cash Value Life Insurance Explained
3
Guardian Life Insurance of America. How to Borrow Money from Your Life Insurance Policy
4
National Association of Insurance Commissioners. Model Policy Loan Interest Rate Bill
5
Protective Life Insurance Company. Universal Life Loans and Surrenders
6
Northwestern Mutual. Borrowing Against Life Insurance With a Life Insurance Policy Loan
7
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
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Office of the Law Revision Counsel. 26 USC 7702A – Modified Endowment Contract Defined
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Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts – Section (v)