Life Insurance✓ Verified · outline & fact-checked · Sep 2026Difficulty 2/5
A policyowner borrows against the cash value of a permanent life policy. If the loan, plus accrued interest, exceeds the policy's cash value, the most likely result is:
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Answer & full 3-part explanation (select an option above, or peek)
Why A is correct
A policy loan is secured by the cash value. Interest accrues on the outstanding loan balance; if the loan plus interest grows to equal the cash value, the policy will lapse because there is no longer collateral securing the debt. Upon lapse, the outstanding loan is treated as a cash distribution, and any amount received in excess of the policyowner's cost basis (premiums paid) is taxable as ordinary income under IRC Section 72.
Why the other options are wrong
- B) Loans are not paid off by dividends; a dividend is a return of surplus in participating policies, unrelated to loan balance.
- C) The death benefit is reduced by any outstanding loan at claim time, not increased.
- D) Loans are never forgiven; the insurer collects the outstanding balance from the death proceeds or upon lapse.
Memory hook
Loan plus interest eats the cash value like rust; when it hits zero, the policy dies and the IRS wants its share.