Consequences of Not Repaying a Borrowed‑Against Life Insurance Policy

If a life insurance policy that has been borrowed against is not paid back, the outstanding loan and accrued interest will be deducted from the policy's cash value, potentially causing the policy to lapse and reducing the death benefit for beneficiaries.

Immediate financial impact

The loan amount plus interest is subtracted from the cash surrender value. When the combined total exceeds the cash value, the policy terminates automatically, leaving no coverage.

Tax implications

When a policy lapses with an outstanding loan, the IRS treats the unpaid balance as a taxable distribution. The taxable amount equals the loan balance minus the total premiums paid, which may push the insured into a higher tax bracket.

Effect on death benefit

Even if the policy remains in force, any unpaid loan reduces the death benefit paid to beneficiaries. The insurer pays the benefit minus the loan balance and accrued interest, so heirs receive less than originally intended.

Interest accumulation

Interest on the loan continues to compound daily or monthly, depending on the policy terms. Over time, the debt can grow faster than the cash value, accelerating the risk of lapse.

Options to avoid lapse

Policyholders can:

• Make minimum payments to keep the loan balance below cash value.
• Pay interest only to prevent compounding.
• Convert the loan into a paid‑up addition, if allowed.
• Consider a partial surrender to cover the loan.

Comparison of outcomes

Long‑term considerations

Leaving a loan unpaid can erode the policy's purpose as a financial safety net. It may also affect future borrowing capacity, as insurers often limit additional loans based on existing debt. Regular review of loan balances and cash value helps prevent unintended lapses.