Interest costs as it pertains to Whole Life insurance is the amount the insurance company charges you, when you borrow their money through a policy loan. Yes, you are borrowing THEIR money; your cash value is the collateral. The loan interest rate that life insurance companies use is usually a variable rate tied to the Prime Rate in some fashion.
Do you want the companies you do business with to be profitable, and maintain sufficient cash flow to cover all of their expenses (ie your death benefit)? Since you probably answered yes… let’s think about why the insurance company charges you interest when you borrow against your cash value. Your death benefit is actually secured by an amount set aside in a reserve as mandated by law, but the insurance company still needs to make good business decisions to be able to service all of the insurance clients that they sell to. Money always has a value and if they do not operate a business recognizing that fact, they will not be in business very long.
The most common question from a client usually is, “Why do I have to pay interest to use my own money?” The answer is, you don’t.
You can withdraw your money out of the life insurance and go on your way. Or you can leave your money in the policy to compound and grow uninterrupted in a vehicle that allows tax-free growth. You would then borrow the insurance company’s money secured by your cash value, a similar approach to a GIC-secured loan. You pay the insurance company an interest rate for the use of their money, much like you would pay a bank to use theirs. Meanwhile, your money continues to grow uninterrupted in your policy and that growth is not eroded by taxes every year. Paying an interest charge is almost in all cases better than paying income taxes on that amount.
“Why pay 5% to a life insurance company, when I can borrow at 4% from a bank?” you may ask. Micro-economically, looking at the question in a vacuum, you shouldn’t. But macro-economically, looking at the big picture, sometimes paying a higher interest rate is worth the increase in flexibility. In your particular situation, you may not be able to get a loan from the bank and may really need the cash. In this case, access to cash from the insurance company may be tremendously helpful even if it might have an interest rate that is a slightly higher than what banks can offer.
Since you control the loan at the life insurance company (unlike at the bank), choosing to pay 5% gives you freedom and flexibility to skip payments, or take longer if necessary to pay it back. The insurance company will not default your loan if you miss a payment but rather, they will capitalize the missed interest payment and simply add it to your loan balance. Not that you should make a habit of this, but it is nice to know that you control the repayment terms and that you have the freedom to miss a payment if you needed to. Additionally, in times of extreme need, if the bank will not loan you any money, you may have no other options to get cash in times of extreme need except from your insurance policy.