What Is A Policy Loan?

Besides the death benefit, one outstanding feature of permanent life insurance (such as universal or whole life insurance) is that it builds up cash value. Your policy turns into an asset you own. Additionally, with whole life insurance in Canada, your cash value keeps experiencing guaranteed growth. This makes life insurance a super stable asset in your financial plan.

A popular strategy gaining traction in Canada is “Infinite Banking” or “Becoming Your Own Banker.” This approach leverages the cash value in your permanent life insurance policy as a personal banking system. One common way to use your cash value is to use it as collateral for a policy loan. This can help with things like paying college fees, covering an emergency expense, or even weathering down markets in retirement. Once you have amassed cash value, you can borrow against it throughout your life for any financial need.

Before you decide to take a loan against your policy, you should be aware of a couple of essential things.

Policy Loans In Canada Explained

A policy loan is a convenient method to access cash whenever you need it, especially if the need arises unexpectedly. By filling out a simple form, you can secure the funds you require from the insurance company, typically within a few days. This method aligns with Infinite Banking strategies in Canada, offering individuals a reliable source of liquidity when needed.

Policy loans generally do not impact your credit score because your policy serves as the loan’s security, and there’s no fixed repayment timetable. Since there’s no formal loan approval process, obtaining the loan doesn’t affect your credit rating.

Repaying Your Policy Loan In Canada

Repaying a policy loan is straightforward and flexible. Unlike conventional loans, there’s no set repayment schedule for a policy loan. You have the freedom to make larger payments in some months or none at all in others. However, it’s important to remember that interest accrues on your loan balance. This means that if you choose not to make payments, the amount you owe will grow over time. Once you fully repay your loan, the policy’s full benefits will be reinstated.

Should you pass away with a loan outstanding against your policy, the death benefit will be decreased by the loan amount. Additionally, suppose the loan balance exceeds a certain threshold. In that case, the insurance company may opt to surrender or “lapse” your policy to cover the loan, potentially leading to adverse tax implications.

How Much Policy Loan Can You Borrow in Canada?

Various policies have their own regulations, but generally, you can borrow against a significant portion of your cash value. Nevertheless, if your loan balance exceeds a certain limit, the insurance company might decide to surrender your policy to settle the debt. Depending on your circumstances, this action could lead to your tax liabilities.

When Can You Borrow A Policy Loan?

Once you’ve amassed adequate cash value, you can borrow against it. However, it requires patience for your policy to accumulate enough cash value for borrowing to be viable. If you need funds, it’s advisable to discuss your options with a financial advisor. While policy loans can be beneficial, there are instances where considering alternatives might be more appropriate.

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Which Life Insurance Policies Offer Policy Loans in Canada?

You can take out a loan against any policy that builds up cash value, such as whole life or universal life insurance. However, if you have a term life insurance policy, it won’t accumulate any cash value.

What Are The Tax Implications of Taking a Policy Loan in Canada?

You’re liable for taxes on any profit when you sell traditional investments. Similarly, surrendering a life insurance policy entails taxes on the gain, typically the amount exceeding your policy’s basis (usually what you’ve paid in). In most scenarios, borrowing against your insurance won’t incur taxes as long as your policy remains active. This is especially advantageous during retirement when you’re strategizing to minimize tax liabilities for the year.

It’s crucial to consult a financial advisor because having a high loan balance can lead to negative tax implications. If you don’t make payments on a policy loan, interest will accumulate, and if left unpaid, it will be included in your loan balance, increasing what you owe. Eventually, if you neglect payments on the principal or interest, the loan balance might match your policy’s cash value. When this happens, your policy will lapse, and two things will occur: the insurance company will cancel your policy and use the cash from the cancellation to pay off the loan balance. In such instances, you won’t receive any cash from the policy’s cancellation.

Now, let’s consider the tax implications. Suppose you surrender your policy without any loans. If your policy has a cash value of $200,000, and you’ve paid $90,000 in premiums, that $90,000 would be tax-free upon surrender. However, the $110,000 gain would be subject to taxation as ordinary income. For instance, if you’re in a 30 percent tax bracket, you’d owe approximately $33,000 to the government. After tax, you’d be left with $167,000.

Now, let’s factor in the loan. Imagine you borrowed $100,000 and never made any payments. With compound interest accumulating over time, if you didn’t repay the loan’s interest or principal, your total loan balance would gradually approach the total cash value. Should the loan balance exceed a certain threshold, your policy would lapse, prompting the company to surrender or terminate your policy (step 1) and utilize the proceeds to settle the loan they provided to you (step 2).

From a tax standpoint, the initial step (policy surrender) is handled identically, whether the funds are utilized to clear the loan balance or withdrawn as cash without any loan. You’d still owe $33,000 in income tax but wouldn’t receive any surrender proceeds from the policy to cover that tax.

Is a Policy Loan in Canada Worth It?

With careful monitoring of your loan balance and guidance from a financial advisor, a policy loan can be a valuable means to swiftly access funds for various financial requirements throughout your lifetime. Your advisor can ensure you comprehend all the ramifications and how the loan fits into your overall financial strategy, empowering you to make a confident decision that aligns with your needs.