Policy lapse with loan occurs when a life insurance policy that has an outstanding policy loan terminates because the combination of loan balance, accrued loan interest, and internal policy charges exhausts the remaining cash value. Once cash value is no longer sufficient to cover monthly cost of insurance and expenses, coverage ends and the contract lapses. For non-MEC policies, this type of lapse can generate unexpected taxable income, because the outstanding loan is treated as a distribution to the extent it exceeds the policyowner's cost basis. Heavily borrowed universal life and variable universal life contracts are particularly vulnerable when interest rates, investment performance, or rising insurance charges undermine projections. Monitoring loan-to-value ratios, updating in-force illustrations, and communicating risk clearly are essential to avoid a lapse with loan and the resulting loss of coverage and potential tax bill.

In real-world servicing, policy lapse with loan is often discovered during an in-force review when the illustration shows the policy running out of value in the near future. Advisors and wholesalers explain to clients that policy loans are not free money and that failing to manage loan interest can allow the loan balance to snowball. Carriers may send special warning notices when a high loan balance threatens the policy's viability. Common mitigation strategies include paying additional premiums, repaying some or all of the loan, reducing the death benefit, or in appropriate cases executing a Section 1035 exchange into a more efficient contract. When a lapse with loan has already occurred, tax and legal advisors may be engaged to help interpret reported gain and explore any limited remedial options available to the client.