Many Canadians take out a life insurance policy as a way to protect their loved ones when they pass away. But did you know that you can use your policy as a resource for a loan?
A policy loan is a unique type of loan that can provide you with quick access to funds. However, policy loans also come with some complexities that you should understand before considering this type of loan.
Let’s go into more detail about policy loans, including when they might make financial sense and the potential costs that may come with them.
What Is A Policy Loan?
A policy loan allows life insurance policyholders to borrow against their policies. These loans are available on most permanent cash value life insurance policies.
Unlike traditional loans, the funds borrowed from policy loans do not have to be repaid. You are essentially borrowing your own money. It is not considered a debt, but rather a deduction in your plan.
If you don’t repay the funds borrowed via your policy loan, that amount will be deducted from your death benefit. That means in the event of your death, your beneficiaries will receive less than what the original benefit was before you borrowed against the policy.
A policy loan is collateralized by the policy’s cash value.
How Does A Policy Loan Work?
You can only borrow against your policy if there is enough cash value associated with it. The available funds borrowed will be a percentage of the cash value of the policy.
It’s important to note that these types of loans are not available on term life insurance policies, as these have no cash value. You also need to pay interest on the borrowed funds. If you don’t make an annual interest payment, the interest you owe will be tacked onto the loan balance.
If you’re interested in borrowing against your permanent life insurance policy, find out what will happen to the value of your policy after the loan. Your insurance provider can supply you with information that will illustrate how your policy’s value will be affected by various scenarios, including if you borrow more money, maintain the loan, or repay it.
How Much Can You Borrow Using A Policy Loan?
There isn’t a specific limit on how much you can borrow against your policy. The amount will depend on the insurance provider and the cash value of your policy. Generally speaking, the maximum policy loan amount is usually around 90% of the policy’s cash value.
Keep in mind that when you borrow against your policy, you’re not taking money from the account’s cash value. You’re simply taking out a loan from the insurance company and using the cash value of the policy to secure the loan. That means the cash value remains unchanged and continues to earn interest.
What To Consider When Getting A Policy Loan
As mentioned, you’ll be charged interest on the amount of money you borrow. Before you take out this type of loan, consider how this interest will be charged, and how much you can expect to pay.
Length Of The Loan
The more time that passes with an outstanding loan, the more interest will accrue on the borrowed funds. At some point, the total loan balance could reach your policy’s cash value. If this happens, you’ll no longer have coverage. Plus, you could be subject to taxation if your policy laps and the loan amount exceeds the cash value.
Be careful about borrowing too close to the full amount of your policy’s cash value, and consider making payments toward interest as much as you can to avoid these potentially costly scenarios.
Interest In Advance
Many insurance providers charge interest for the entire year. In this case, you’d have to pay interest in advance. Even if you took out the policy in the middle of the year, the insurer would charge interest from when you take the loan out to cover the remainder of the year.
Keep in mind that if you make a loan repayment during the policy year, you may not be credited or refunded the interest you paid in advance.
Interest In Arrears
Your insurance provider may charge interest at the end of the policy year, known as interest in arrears. Interest accumulates every day, which means it will start to accumulate the day you take out the policy.
If you make a loan repayment at any point throughout the year, the daily loan interest amount would decrease. In turn, the loan interest payable at the end of the policy year would also be reduced.
How To Get A Policy Loan
Taking out a policy loan is easy. All you need to do is complete a form with your insurance provider, and the funds should be accessible within a few days.
However, a few extra steps may be required if the policy recently changed ownership or if you’re requesting a very large loan amount. In this case, you may need to sign a confirmation document.
Benefits Of A Policy Loan
There are a few perks to a policy loan compared to applying for a traditional loan, including the following:
- No need to qualify. Conventional loans require that you meet certain eligibility criteria in order to get approved. But with policy loans, you don’t have to go through the qualification process. That means there’s no need to prove your employment or income, and no credit check is involved.
- Flexibility in repayment. You don’t have to adhere to any strict repayment due dates when you take out a policy loan. In fact, you don’t have to repay the loan at all, so long as the loan and interest don’t exceed the value of the policy’s cash value. There’s also flexibility on when you pay the annual interest, though it’s important to keep in mind that interest will continue to accrue. So, the sooner you repay the loan, the less interest you’ll pay.
Risks Of A Policy Loan
Along with the benefits of policy loans are a handful of drawbacks to consider:
- Tax issues. The money you borrow against your policy is not taxable, as long as it doesn’t exceed what you’ve paid into the policy. If your policy lapses or you surrender your policy and the amount your borrowed is greater than what was paid into the policy, you will be subject to taxes.
- Living longer than your expected lifespan. When you take out a policy loan, the loan amount will be based on the anticipated cash value at the time of your passing. Then, the maximum loan amount is based on a percentage of the expected accumulated cash value and returns. If you live longer than the estimated death date, you may need to either pay off part of the loan or offer more collateral.
- High cost. The larger the loan and the longer you keep it, the more it will cost you and the bigger impact it will have on your policy. As noted, you’ll be paying interest on your loan. So, if your interest rate increases or your cash value returns decrease, it can cause your loan to outpace your policy’s cash value. If this happens, your lender may request an early repayment or collateral to reduce their risk.
Should You Get A Policy Loan?
A life insurance policy loan might make sense in certain situations, including the following:
You Can’t Qualify For A Traditional Loan
Even if your credit may have been checked when you initially took out your policy, there’s no credit check required for a policy loan. Things can change in your financial life over the years that might make it more difficult for you to qualify for a conventional loan.
All you need to do to take out a policy loan is fill out a form with your insurance provider. As long as no major changes to your policy have been made and you’re requesting a reasonable loan amount, you should have access to your policy funds almost immediately.
You Need Fast Cash
The funds of a life insurance policy are readily available, which makes this type of loan convenient for those with an urgent need for extra cash. You can use the money to cover costs such as fixing your home’s furnace or repairing your car after an accident.
Your Premiums Are Too Much To Handle
If you can no longer afford your premium payments, you should take immediate steps to avoid allowing your policy to lapse. In this scenario, taking out a policy loan to cover part of your premiums can allow you to keep the policy in effect.
Other Loan Options Are More Expensive
Consider the interest rate you’ll be charged on a policy loan versus other loans. If you can secure a much lower interest rate on a policy loan, you can save a lot of money in interest.
Policy Loan FAQs
Should I pay back my whole life insurance loan?
Can you borrow against your life insurance policy?
Will a loan from a life insurance policy be taxed?
Final Thoughts
A policy loan may be a great way to access funds right away without having to jump through all the hoops that come with applying for a conventional loan. However, they may come with some tax implications and other costs. And if you don’t repay the funds, your beneficiaries will be left with a smaller payout.
