Using life insurance as loan collateral

You might only think of life insurance as a way to support your family after you pass away. When you pass away, your family may lose you as a significant income source, but life insurance is there to provide them with a death benefit to cover their cost of living, education, and more! 

But, that’s it, right? You may have the idea that life insurance is only beneficial after you die—but you can reap living benefits too! There are many ways life insurance, especially permanent life insurance, can be useful for you while you’re alive.  

Business owners leverage life insurance to cover employees who are critical to their business operations or to facilitate buy-sell agreements. A corporation may even hold a life insurance policy to mitigate the financial risks associated if the primary shareholders or key management personnel pass away. 

However, even an individual policyholder can benefit from their policy during their lifetime, while they pay their premiums. Loan collateral is another way individuals and corporations use life insurance. Lenders provide a loan on the contingency that they receive your life insurance payout if you cannot repay the loan. 

This article explains the different ways you can borrow from your policy and, more specifically,  how collateralizing your policy works. It further details the types of life insurance you can use as collateral, how much you can borrow, in addition to the benefits and drawbacks of using life insurance as loan collateral.

How to borrow from a life insurance policy

A permanent life policy accumulates cash value. The cash value is the part of your premium that your insurer allocates to a savings or investment account. It accumulates value over time, and you’re able to access and use this money before your death. Commonly, this value is utilized in a couple of ways when you need cash immediately. 

• Use your cash value as collateral for a loan

A bank or lender uses the cash value of your policy as collateral for a bank loan. They know that if you can’t make your loan payments, you can always cancel your life insurance policy and pay the bank with your remaining cash value.  

Depending on your policy, there might be restrictions to the amount of money you must accumulate before you can borrow against it. If you can’t repay your loan, the lender may seek repayment from your policy’s cash value, which cuts into the death benefits your intended beneficiaries will receive.

• Taking out a policy loan/advance

This method is similar to using your policy as collateral, except the lender in this case is the insurance company, not a bank or creditor. Think of it as an advance on your death benefit. You can repay this loan, so your death benefit doesn’t take a hit. This is a great option for those that need cash, but wouldn’t be able to obtain a loan from the bank due to low income or low credit score. 

• Withdraw your cash value 

Some policies also allow you to withdraw some or all of your cash value, for a fee. You might use this option if you need to make a large purchase and are low on funds. There are generally penalties for early withdrawal of the cash, also referred to as the surrender fees. Your policy’s cash value minus the surrender fees is what your “cash surrender value” will be. In some cases, this penalty can be a few hundred dollars, but in other cases, it may be a percentage based on the cash value accumulated. With policy withdrawals, the loan is final and cannot be repaid—whatever you take will reduce your death benefit. This is an option for you if you’re short on cash, but may wipe out your death benefit altogether depending on the withdrawal. 

Each of these options has specific tax implications on the amount you withdraw. We’ll get into the tax requirements in later sections.

Can you use life insurance as collateral for a loan?

Yes! You can use certain types of life insurance policies as collateral for a loan. To initiate the loan, you usually first speak with a lender. This might be a major Canadian bank or another creditor. You should understand the standard loan terms affiliated with the loan, such as the interest rate and payment terms. 

You must further speak with your insurer to notify them that you’re using your policy as collateral. Generally, insurers are disinterested in how you use your policy as long as you meet the obligations of your life insurance contract — i.e., making timely premium payments.

What kind of insurance can be used as collateral?

Life insurance policies such as universal life and whole life insurance that have a cash value component are the most suitable for collateralized loans. (Read more about whole vs. universal life insurance)

Most lenders won’t accept term life policies as loan collateral because they don’t accumulate cash value. Additionally, term policies may be too short to accommodate the life of the loan. Let’s assume a lender accepts a term life policy as collateral. The collateral would disappear once the term was up, turning the loan into unsecured debt. This creates significant risks for the lender. 

Instead, lenders almost always ask for permanent insurance policies as collateral in a life insurance-backed loan. These policies don’t have a set term and last as long as you maintain your premium obligations. Permanent policies (excluding a term-to-100) build the cash value that is needed for the lenders to let you borrow against.

How does using my cash value as collateral work?

Collateral assignment of life insurance conditionally appoints your lender (the bank) as the primary beneficiary to the death benefit. To the lender, your life insurance is a source of guaranteed funds. 

If you’re unable to repay the loan, the lender can either cash in the insurance policy for the cash surrender value or wait until you pass away to receive your death benefit as repayment for the loan. 

Some borrowers intend only to repay the loan with their life insurance proceeds. However, if you repay the lender before your death, the death benefit assignment is removed, and the lender is no longer the beneficiary.

How much can you borrow from a life insurance policy?

Generally, a lender allows you to borrow 50 to 90 percent of the cash value when you collateralize your life insurance policy. This percentage considers your credit score and how and if your insurance company invests your cash value amount. 

The lender may hold back from lending a high percentage of the cash value to riskier borrowers so that the policy retains a sufficient cash value to accommodate missed interest payments. 

Additionally, your policy may accumulate cash value at a slower or lower rate than the bank’s loan interest rate. This means there remains risk that the loan balance exceeds the cash surrender value. This might require the lender to ask you for additional collateral or partial loan repayment.

Why use life insurance as loan collateral?

Life insurance as loan collateral means your personal property and assets are safe. If you’re unable to pay back the loan, you’re not risking your home, car, or other belongings, which is the usual case with secured loans. 

Lenders also like life insurance policies as collateral because there’s a certainty. They know the policy’s cash surrender value and the death benefit’s value. In contrast, if you collateralize your car, your car’s value depreciates over time. You might also damage it and further reduce its value. And while homes appreciate over the long term, there’s no telling whether someone collateralizing their home will default in an up or down housing market. 

Lastly, life insurance collateralized loans can be even more affordable than an unsecured loan with a high-interest rate. Secured loans mean less risk to the lender, which means a lower interest rate for you. It’s possible for the sum of the life insurance premium and interest rate of a life insurance-backed loan to be lower than the interest rate of an unsecured loan.

Will loan proceeds from a life insurance policy be taxed?

When determining if loans will be taxed, regulatory bodies look at the policy’s adjusted cost base (ACB). In the case of the life insurance policy, the ACB is the policyholder’s cost of maintaining the policy, which includes all costs paid other than the net cost of pure insurance. For example, if the annual premium for a whole life policy is $5000, perhaps $1500 of this accounts for the cost of insurance, $3000 is invested to build cash value, and $500 is charged for maintaining the policy. In this case, the ACB for this policy would be $3500.

As mentioned above, the tax implications of your loan will depend on how you borrow from your life insurance policy.

Policy Withdrawals – Whenever the amount withdrawn exceeds the policy’s ACB, the whole loan will be taxed. 

Policy Loans – Only the amount over the ACB will be taxed. 

Policy as collateral – Loan proceeds can be received tax-free.

Is a life insurance policy loan dangerous?

Using your life insurance as loan collateral comes with several risks:

• Tax complications: Although life insurance proceeds are tax-free, the capital gains on your invested cash value account may create a tax liability. This liability can be an issue if left unchecked.
• Outliving your projected death: When you get your policy loan, the bank will base the loan amount on the projected cash value at the time of your death date. While term coverage has a designated expiration date, permanent policies still have an estimated life expectancy date that is based on actuarial data from the insurance company. It considers your health and lifestyle data and predicts the date you may pass away. The maximum loan amount is then based on a percentage (usually 50-90%) of the projected accumulated cash value and projected returns. If you live past this projected death date,  which might require you to provide additional collateral or pay off a portion of the loan.
• Assumptions about interest and return rates: Your bank considers its interest rate with respect to the rate of return on your cash-value account. If the interest increases and/or the rate of return decreases, the difference between these two rates widens. As a result, the loan balance may outpace the policy’s cash value faster than projected. This can also cause the lender to ask for additional collateral or early repayment. 

While these risks are present, the proper insurance, investment, and tax advice can prepare you for these issues. 

A collateral assignment of life insurance is one way to leverage your policy’s cash value during your lifetime. It’s a popular method to access cash for your personal or business needs. Such a loan can be better than traditional secured loans, which collateralize your personal assets. 

Speak to one of PolicyAdvisor’s expert insurance advisors today to learn how you can leverage your life insurance in a loan. Our team can explain the process and suggest steps to reach your financial goals. Book a call with one of our advisors today!

The information above is intended for informational purposes only and is based on PolicyAdvisor’s own views, which are subject to change without notice. This content is not intended and should not be construed to constitute financial or legal advice. PolicyAdvisor accepts no responsibility for the outcome of people choosing to act on the information contained on this website. PolicyAdvisor makes every effort to include updated, accurate information. The above content may not include all terms, conditions, limitations, exclusions, termination, and other provisions of the policies described, some of which may be material to the policy selection. Please refer to the actual policy documents for complete details. In case of any discrepancy, the language in the actual policy documents will prevail.  All rights reserved.

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