Life Insurance Loans:  Where does the interest go?  The Whole Truth:

  Life insurance companies charge interest when we borrow their money just like banks and credit unions and other financial institutions do.  Many statements are made in the market place about how we borrow our cash value.  This is incorrect. The whole truth is we borrow against our cash value, or to be more specific we borrow the insurance companies’ money and use our cash value as collateral.  They charge us interest for this privilege because we have now removed money from the pool of capital they have to invest.  This is a good deal for everyone because the insurance company earns money, the owner of the policy gets use of the money while at the same time their cash value keeps growing and all the other policy holders know the insurance company is investing their money properly since the interest charged is reflective of the rates in the market place. One might question the “market place” rate.  Some companies charge a fixed rate, some charge a variable.   Some have both available due to direct recognition.
 There are two different methods insurance companies use to handle the loaned cash value — direct recognition and non-direct recognition. In a non-direct recognition company, the earnings rate on cash value is totally unaffected by any loans against cash value. In a direct recognition company, the earnings rates on loaned cash value are affected both positively and negatively when the cash value is used as collateral. 
Generally, with a direct recognition contract, the collateralized cash value has a dividend rate that is a certain number of basis points lower than the interest charged on the loan. So if the current-gross-dividend-crediting rate is less than the gross-direct-recognition-crediting rate, then the collateralized cash value is affected positively. If the current-gross-dividend-crediting rate is greater than the direct-recognition-crediting rate, then collateralized cash value is affected negatively.  For example, let’s say the current-gross-dividend-crediting rate is 6.5 percent, and the loan rate is 8 percent with all loaned cash value getting a “100 basis point” (1 percent) reduction from the loan rate (bringing it down to 7 percent). That being the case, since 7 percent is obviously greater than 6.5 percent, borrowing against your cash value actually improves your situation because your gross-dividend-crediting rate will be at 7 percent for the borrowed cash value and 6.5 percent for the non-borrowed cash value. After all the analysis we’ve done on many companies and policies, we’ve found either way works just fine. Maybe consider having both!
 The interest charged by the insurance company goes to the insurance company, not to your policy directly.  The reason for this is that when you borrow dollars from the insurance company, it comes out of the insurance companies’ investment pool and therefore they need to charge an interest rate for it to re place the interest they would have lost if it had stayed invested.
This interest does not add to your cost basis or directly increase the policy’s cash value that is being collateralized.  However, the earning of the life insurance company (both from their investments in the market place as well as their investments in policy loans) are what they use to pay dividends to all policy holders. If you choose to pay at a rate higher than what the insurance company charges, then this higher amount (the difference between what they charge and what you pay) can go to your existing policy in the form of a Paid Up Addition (PUA) which would increase basis, or to a new policy as premium so either way that can go to build your cash value. As a reminder, PUA money goes 95% or so to cash value with only 5% or so increasing death benefit. This drastically raises the amount  available to you for use in future years and is the most efficient place to store cash.