When To Take a Policy Loan From Your Life Insurance

In Canada, policy loans from life insurance policies provide a convenient avenue for accessing fast cash at favorable interest rates. However, while these loans offer attractive terms, they also come with certain limitations.

The majority of Canadians get life insurance to help their families financially when they pass away and lose their income. But some life insurance lets you borrow money from the policy while you’re still alive.

Taking out a loan from your life insurance policy has big benefits compared to borrowing from a bank or using credit cards. However, it’s important to remember that it’s still a loan. If you don’t pay it back, there are consequences.

What is a life insurance policy loan?

Term life insurance only pays out if you pass away during the policy term. However, with permanent life insurance, also known as cash-value life insurance, you get a payout whenever you die. Some of your premium goes into a separate account that grows in value over time.

When the cash value reaches a sufficient amount, you can utilize it for:

• Increase the life insurance death benefit by purchasing additional coverage.
• Cover the premiums for a whole life insurance policy or handle the expenses and coverage costs for a universal or indexed universal life insurance policy.
• Withdraw cash. If the money isn’t repaid, the death benefit gets reduced.
• Take a loan from the life insurance company, using the cash value as collateral. Similar to cash withdrawals, the insurer will decrease the death benefit if the borrowed amount isn’t repaid.

Getting cash, no questions asked

When you require funds for medical bills or your child’s college fees, borrowing against your life insurance cash value offers several benefits compared to taking out personal loans or using credit cards.

Pros of a policy loan

1. No credit check

• If you have sufficient cash surrender value, you can borrow without facing any inquiries. However, it’s essential to recognize that accumulating this value often requires years or even decades.
• Unlike bank loans, there is no application process. You complete a form, and the payment is issued to you.
• Unlike credit card debt, policy loans don’t appear on your credit report.

2. Low-Interest rate

Life insurance policy loans probably come with lower interest rates compared to bank loans or credit cards.

3. No set timeframe for paying back

• The loan repayment process is flexible and you can repay it at your own pace.
• Repayment of the loan is not mandatory, but if left unpaid, the outstanding amount is subtracted from the death benefit of the policy.

4. The policy remains eligible to earn interest and dividends

Even though the insurance company will levy interest on policy loans, you’ll still earn dividends or interest on the borrowed amount. However, this rate is typically lower than what you’d receive on funds not borrowed.

Cons of policy loans

Every means of obtaining fast cash has its downsides, and policy loans are no different.

1. May be unavailable

Accumulating substantial cash value in a permanent life insurance policy often requires many years. During the initial years of the policy, there may be minimal, if any, value available to borrow against.

2. Potential for a decreased payout

• Despite potentially favorable rates, interest is still charged on life insurance loans. Since this interest is typically deducted from the cash value, it can catch you off guard.
• If the total amount of your loan plus interest surpasses your policy’s cash value, the policy might lapse.

3. Potential tax consequences

If your policy lapses before fully repaying the loan, you might owe income tax on the outstanding amount. However, you can typically recover the “cost basis” of your policy, which is usually the premiums paid, tax-free. Any amount received beyond the cost basis is subject to income tax.

Is borrowing from cash-value life insurance a good idea?

Borrowing against your life insurance is a viable option instead of accumulating credit card debt or facing high interest rates on personal loans.

Handle any loan from your life insurance company with caution:

• Stay vigilant about the accumulating interest on your loan.
• Establish your own timeline for repaying the loan.
• Adhere to your repayment plan. If you’re not planning to repay the loan, consider opting for a cash withdrawal to avoid accumulating interest.
• Prior to obtaining a policy loan, ask your life insurance company for an in-force illustration. This document will detail how the loan will affect your policy’s future performance. If you decide to proceed with the policy loan, request an in-force illustration every one to two years to track its impact on performance.