Using life insurance as loan collateral
Your permanent life insurance policy accumulates a cash value over time. You can use this cash value as loan collateral, depending on how much value your policy accumulates. If you default on your loan and the policy value has to be used, this will cut into your death benefit, plus interest. You can also borrow money directly from your policy, but with interest.
You might only think of life insurance as a way to mitigate financial risks associated with someone’s death. If you pass away, your family may lose a significant income source, but life insurance is there to provide them with a death benefit.
That’s it right? You may have the idea that life insurance is only beneficial when you die—but there are many ways life insurance can be useful for you while you’re alive as well! You can reap living benefits too.
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 operators die.
However, even the average policyholder can benefit from their policy 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. Sometimes, the lender may be your insurer, and this is commonly referred to as a policy loan.
This article dives into the topic of life insurance as loan collateral. It explains how you can use a policy as collateral and how such a loan works. It further details the types of life insurance you can use as collateral, how much you can borrow based on your policy, in addition to the benefits and drawbacks of using life insurance as loan collateral.
Can you use life insurance as collateral for a loan?
Yes! You can use your life insurance policy as collateral for a loan.
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 death benefit 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.
- 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. This is an option for you if you’re short on cash, but it will reduce your death benefit or wipe it out all together depending on the withdrawal.
Because of the possible fees or reduction of the death benefit, you may be able to receive more capital by borrowing against the cash value of your life insurance policy than by withdrawing it.
What kind of insurance can be used as collateral?
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 whole or universal life 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 lenders let you borrow against.
How does a life insurance policy loan 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.
To initiate the loan, you usually first speak with a lender. This might be a major Canadian bank, or your insurer may facilitate a policy loan itself. 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.
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. 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.
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: Some policy loans 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%) of the projected accumulated cash value and projected returns. If you live past this projected death date, it might require you to provide additional collateral or pay off a portion of the loan.
- Assumptions about interest and return rates: Your loan 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 provided herein is for general informational purposes only. It is not intended and should not be construed to constitute legal or financial advice.
- Permanent policies allow you to utilize the policy’s cash value as a living benefit
- You can borrow against this cash value when you need a bank or lender loan
- You can also take a life insurance policy loan where you borrow some of your death benefit