How Interest Works on Life Insurance Loans

Interest on life insurance loans accrues at  daily, or at  annual simple interest. Let’s break this down… 

We’ll start with annual simple interest. If one takes a life insurance loan out, the insurance company will charge simple interest for an annual term. Then we have the daily accrual. This can cause concern for any consumer when we hear the term “daily interest.” Fortunately, we don’t need to be concerned. Interest accrues each day, but at simple interest over the course of the year. Knowing this can be confusing. Here is an example:  

• Policy Loan: $10,000
• Loan Interest Rate: 5%
  • [$500 over 365 days; divide $500 by 365 days = $1.37/day, so after 365 days, our loan interest has accrued to $500] 
• Total Loan Balance: $10,500 

If the loan interest is not paid, the policy will borrow $500 to cover the loan interest charge. The new balance of $10,500 will then be charged 5% annual simple interest, which will accrue daily.  The daily accrual is something that can be used to our advantage once we have an understanding.  Whenever a life insurance illustration is presented, it will assume one repays a policy loan at the  end  of the year.

This is important to understand because at that time, the interest would have accrued over the course of a full year, and we would owe the full amount in interest.  We have the option to pay life insurance loans whenever we want. If, for example, we decide to pay a loan of six months into a policy year, we would only have to pay loan interest for the six months of accrual. Here is an example:  

• Policy Loan: $10,000  
• Loan Interest Rate: 5%
  • [$500 over 365 days; divide $500 by 365 days = $1.37/day. Policy loan paid off in 6 months.  $1.37 x 6 months = $250] 
• Total Loan Balance on Payoff Date: $10,250

The main takeaway for this is that making loan payments prior to the anniversary date will often lessen our interest expense.  

The last point on how interest works for life insurance loans is the topic of billing over the course of a policy year and upfront.  Some life insurance companies will bill the full loan interest at the beginning of a policy year. This does not mean that we owe all the interest upfront. While the interest is billed upfront, it will still accrue daily. If, for example, we paid the loan off in six months the total interest paid to the insurance company would be the same as it would be if the company billed interest over the course of the year. In this case, the insurance company would refund the amount they billed upfront to our cash value. Here is an example:  

• Policy Loan: $10,000
• Loan Interest Rate: 5%
  • [$500 over 365 days BILLED UPFRONT; divide $500 by 365 days = $1.37/day as the interest still accrues daily.  Policy loan paid off in 6 months.   Loan balance prior to payoff reads $10,500 as it was billed upfront . $1.37 X 6 months = $250] 
• Total Loan Payoff After 6 Months: $10,250 

To sum it up, if a policy bills the interest as a year passes or upfront, the actual loan interest accrual is the same as when loan interest accrues daily at annual simple Interest.