What Happens If a Policy Loan Causes a Lapse?
How a loan quietly turns into a lapse
A policy loan doesn't have a due date, which sounds friendly and is exactly where the risk hides.
The carrier charges interest on the loan. If you don't pay that interest, it gets added to the loan balance. Now the bigger balance accrues even more interest next year. Meanwhile your cash value is what's backing the whole thing.
Let the loan grow long enough and it climbs toward your cash value. When the loan plus accrued interest gets close to, or past, the cash value, the policy can no longer support itself, and it lapses.
Nobody decides to let this happen. It happens by not looking.
The part that surprises people: the tax bill
While the policy is in force, a loan isn't treated as income. But if the policy lapses with a loan outstanding, the IRS can treat the gain (roughly, the amount your value grew above what you paid in) as taxable ordinary income.
So the worst case isn't just losing the coverage. It's losing the coverage and getting a tax form for money you borrowed and spent long ago, with no death benefit left to show for it.
The number to watch
One ratio tells you almost everything: your loan balance compared to your cash value.
- Early on, with a small loan, you're fine.
- As that ratio climbs (say, past 80-90%), you're in the danger zone, and many carriers will send a notice.
- If it hits 100%, lapse is imminent unless you act.
Ask your carrier where you are on that ratio, and whether they'll alert you before it crosses the line.
How to keep it from ever happening
- Pay the interest at least once a year. This single habit stops the compounding that drives the whole problem.
- Check the ratio annually. Cash value and loan balance both move; look once a year, not once a decade.
- If you're near the line, act early. Paying down part of the loan or adding premium can pull the policy back from the edge. The earlier you do it, the less it takes.
- Don't ignore carrier notices. A lapse warning is a deadline, not junk mail.
Get the policy loan risk checklist. How to find your loan-to-cash-value ratio and the steps to take if it's climbing.
Get the checklistFAQ
How does a policy loan turn into a lapse?
A policy loan has no due date, so unpaid interest gets added to the balance, and the bigger balance accrues even more interest the next year. Let it grow long enough and the loan plus interest climbs toward your cash value. Once it can't be supported, the policy lapses.
Can I really owe tax on a loan I already spent?
Yes, and it surprises people. While the policy is in force a loan isn't treated as income, but if the policy lapses with a loan outstanding, the IRS can treat the gain as taxable ordinary income. Tax outcomes depend on your basis, so confirm with a tax advisor.
What number should I be watching?
Your loan balance compared to your cash value. Early on with a small loan you're fine; as that ratio climbs past roughly 80-90% you're in the danger zone, and at 100% a lapse is imminent unless you act.
How do I keep this from happening?
Pay the loan interest at least once a year to stop the compounding, check the ratio annually, and act early if you're near the line. And don't ignore carrier notices: a lapse warning is a deadline.
Sources
- Investopedia: Life Insurance Policy Loans: Pros and Cons investopedia.com (accessed 2026-06-28)
- IRS: Publication 525, Taxable and Nontaxable Income irs.gov (accessed 2026-06-28)
- NAIC: Life Insurance (consumer) content.naic.org (accessed 2026-06-28)
This article is for general educational purposes only and is not insurance, tax, or legal advice. Cove does not sell insurance and is not affiliated with any insurer. Any figures are illustrative and vary by policy, carrier, and state. Confirm specifics with your carrier and a qualified tax or legal professional. Last updated June 2026.