Borrowing against your life insurance policy can be an attractive option when you need access to funds. But is it the right financing choice for you? This guide explains how borrowing against life insurance in Canada works, helps you determine whether it’s a smart move for your situation, and outlines what to consider before taking out a loan against your policy.
What is Borrowing Against Life Insurance?
Borrowing against life insurance allows policyholders to access part of their policy’s cash value through a loan. This option is only available with permanent life insurance policies that build up cash value over time. Once this value reaches a sufficient amount, you can borrow against it without undergoing a credit check.
| Policy Type | Cash Value? | Ability to Borrow Against Policy |
|---|---|---|
| Term Life | No | No |
| Whole Life | Yes (Guaranteed growth) | Yes |
| Universal Life | Yes (Growth depends on investments) | Yes |
How Does the Borrowing Against Life Insurance Process Work?
If you have a whole life insurance or universal life insurance policy, here is an overview of how borrowing against it works:
Cash Value Accumulation
As you pay premiums over many years, your cash value grows. In a whole life policy, this growth is typically guaranteed at a minimum cash value set out in the contract. Some whole life policies may also pay additional amounts (such as dividends) that are not guaranteed and can change over time
In a universal life policy, the growth is tied to the underlying investments you choose, meaning it can fluctuate.
Loan Request and Approval
You can request to borrow against your cash value once it reaches the minimum threshold set by your insurer. The amount you can borrow is often tied to a percentage of your policy’s cash surrender value, but limits differ by institution and your contract. The insurer will review your request and policy details before approving the loan.
Receiving and Repaying the Loan
The funds are typically deposited into your bank account within a few days to a week.
You are not required to make regular payments. Interest accrues on the loan balance and is added to the amount you owe. However, it is highly advisable to at least pay the annual interest to prevent the loan from compounding and growing uncontrollably.
The Tax Consequences: A Critical Risk
This is the most dangerous and least understood risk. While a loan itself isn’t taxed, a problem arises if the policy lapses or is surrendered while a loan is outstanding.
In this scenario, the Canada Revenue Agency (CRA) treats the outstanding loan balance as a withdrawal. If that amount, plus any other cash withdrawn, exceeds your policy’s Adjusted Cost Basis (ACB), the total net premiums you have paid, the difference is considered a taxable gain and must be reported as income (Income Tax Act).
Why Do You Need To Borrow Against a Life Insurance Policy?
There are several situations where borrowing against your permanent life insurance policy can be useful:
- Fast access to funds: The life insurance loan process is often much faster than taking out a traditional personal loan or home equity loan. Within just days or weeks, you can have funds deposited into your bank account. This speed makes it advantageous when you need money urgently for something like medical bills, emergency home repairs, or other unexpected costs.
- Lower interest rates: Interest rates on life insurance policy loans are typically lower compared to other options like credit cards, personal loans, or home equity loans. The lower interest rate helps save money over the duration of repaying the loan.
- No credit check: Because a life insurance loan does not require a credit check, it does not impact your credit score. This can be useful if you already have a lot of outstanding debt or loans and don’t want further credit checks to negatively influence your credit profile.
- Tax-advantaged: Current tax laws allow life insurance loan proceeds to be received free of income tax. This differs from withdrawing cash, which may trigger tax liability. The tax-free nature provides financial leverage.
- Flexible repayment terms: Most life insurance policy loans do not have a set repayment term. This gives you flexibility in repaying the loan on a timeline that matches your financial situation. There is no pressure of a fixed monthly loan payment.
- Supplement retirement income: The tax-advantaged funds borrowed can provide income now while maintaining the death benefit to cover final burial/cremation expenses.
Overall, borrowing against a permanent life insurance policy creates unique financial flexibility that may suit specific borrowing needs or situations. In many cases, it can serve as an advantageous financing option compared to alternatives.
The Drawbacks of Borrowing Against Life Insurance
Taking out a life insurance policy loan also has some disadvantages to consider:
- Reduces death benefit: If you die before repaying the loan, the balance plus interest is deducted from the death benefit your beneficiaries would receive.
- Risk of lapse: A default on the loan could potentially cause your policy to lapse if the debt exceeds the cash value amount.
- Access limitations: You need to accumulate a significant cash value before being able to borrow a substantial amount against your policy.
- Interest accumulation: Unpaid interest gets added to the loan balance, allowing it to grow quickly.
- Only for permanent policies: Borrowing is only available if you have a whole life insurance or universal life insurance policy.
Consider both the advantages and risks before deciding if borrowing against your life insurance is the right financial move for you.
What Are Some Alternatives to Borrowing Against Life Insurance?
Borrowing against life insurance is not the only way to access tax-advantaged funds from your permanent policy. Here are a couple of alternatives to consider:
Policy Withdrawals
Instead of taking out a loan against your cash value, you can withdraw funds directly from the policy. Any amount withdrawn above the cost basis (premiums paid) will be subject to income tax. Withdrawals also reduce the death benefit permanently.
Traditional Loan Options
You may want to explore borrowing against home equity or an unsecured personal loan rather than your life insurance. This avoids putting your policy and death benefit at risk. The interest rates may be higher, but it keeps insurance and financing separated.
When evaluating alternatives, think about your timeline, repayment plan, risks, and overall financial planning goals. Consulting an advisor can help identify the best funding option
Questions to Ask Before Borrowing Against Your Policy
If you’re considering a loan against your life insurance policy, here are some important questions to ask yourself:
- Why do I need to borrow money against my life insurance policy versus other options? What is my plan for repayment?
- How much cash value do I currently have in my permanent life insurance policy? How much can I borrow?
- How will borrowing against my life insurance impact the death benefit for beneficiaries?
- What is the interest rate on policy loans with my insurer? How does it compare to other financing options?
- Do I have other financial assets I can borrow against or liquidate instead?
- Does borrowing against my specific policy align with my overall financial goals?
- How much time will I have to repay the loan before it becomes problematic?
- What tax implications or risks could borrowing against my policy create?
Thinking through questions like these will ensure you fully understand the implications before moving forward with a life insurance loan.
What Tips Should You Follow When Borrowing Against Life Insurance?
If you decide to take out a loan against your permanent life insurance policy, make sure you follow these tips:
- Review your policy thoroughly: Before even applying for a loan, understand your life insurance policy inside and out. Look at your contract to see your premiums, cash value accumulation, death benefit, and loan provisions. Know your current cash surrender value and how much you can borrow.
- Research interest rates: Interest rates on policy loans can vary by insurer. Compare rates not just across life insurance companies in Canada but also against other financing options like personal loans or home equity loans. This helps you maximize savings.
- Conservatively estimate longevity: If basing the loan amount on life expectancy, use a very conservative estimate of your lifespan. Assume you’ll live until advanced age, like 90 or even 100, to prevent the loan balance from growing too large.
- Pay interest annually: Make interest payments on the loan annually or as frequently as possible. This prevents the interest from being added to your principal loan balance and compounding rapidly.
- Consult a financial advisor: It’s wise to meet with a financial advisor to discuss your situation before deciding to borrow against life insurance. An advisor can review your finances and suggest the best funding options.
- Read the fine print: Don’t gloss over the loan agreement details. Read every word carefully to fully understand the interest charges, repayment terms, risks of default, and impacts on your policy.
- Use a fixed interest rate: Opt for a fixed interest rate over a variable rate. This locks in your low-interest cost over the duration of the loan.
- Have a repayment plan: Develop a clear repayment plan for the loan rather than just intending to pay it back eventually. Prioritize repaying the principal quickly.
- Review annually: Check the loan balance each year on the anniversary date. Make sure unpaid interest hasn’t caused it to balloon.
Following these tips helps mitigate risks and puts you in a stronger financial position when borrowing against your life insurance policy’s cash value.
The Bottom Line
Borrowing against your permanent life insurance policy provides access to tax-advantaged funds and avoids credit checks or damage. However, there are also risks to weigh when borrowing against your policy’s cash value. Carefully consider your goals, evaluating both the benefits and drawbacks, before deciding if borrowing against life insurance is the right move for your situation.
FAQs on How to Borrow Against Life Insurance
What types of life insurance allow you to borrow against the policy?
Borrowing against a life insurance policy is only permitted with permanent forms of life insurance like whole life and universal life. This is because permanent policies are the only ones that build up cash value, which is used as collateral for the loan. Term life insurance does not have a cash value component, so borrowing is not an option.
Can I borrow against my life insurance from the insurer or a third-party lender?
Policyholders can take out a loan against their cash value directly from the insurer. This is called a policy loan. It is also possible to get a loan from a financial institution like a bank using your life insurance as collateral. Both options allow you to borrow against your policy's cash value.
How much money can I borrow from my permanent life insurance policy?
In most cases, you are able to borrow up to 90-95% of your policy's cash surrender value. The exact amount will depend on factors like your insurer, policy type, cash value, and potentially your age or health. Older insureds may not be permitted to borrow up to the full threshold.
Does borrowing against my life insurance impact my credit score?
No, borrowing against your life insurance policy does not affect or require a credit check. Because the cash value acts as collateral, there is no need to assess your creditworthiness. This is a major advantage over traditional loans that do influence your credit profile.
Are life insurance policy loans taxable?
Generally, funds borrowed against a life insurance policy's cash value are not subject to income tax. Loan proceeds are only taxed if the amount borrowed exceeds your cost basis in the policy. This is one reason why borrowing can be tax-advantaged compared to other options.
What are the risks associated with borrowing against life insurance?
A few key risks include reducing the death benefit if the loan remains unpaid at the time of death, potential policy lapse if debt exceeds cash value, and owing income tax on gains if you surrender the policy. Unpaid interest accumulating can also allow the loan balance to grow quickly. While there are risks, they can be managed by borrowing conservatively and repaying promptly.
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