How to use Life Insurance as Loan Collateral?

Life insurance pays out a death benefit to your loved ones when you pass away. However, it can also be used for other purposes.

Permanent life insurance plans, such as whole life insurance, accumulate cash surrender value that can be used as collateral assignment for a loan. Lenders may allow you to borrow 80% to 100% loan-to-value if you offer your policy as collateral assignment.

The cash surrender value component transforms your policy into a tangible asset, similar to a car or your home. If you default, the lender can recover the loan amount from the cash value of your policy.

How to borrow from a life insurance policy?

Whole life and universal life insurance are two forms of cash value permanent life insurance products. When you pay your life insurance premium, the insurer uses it for three purposes:
• To pay the cost of life insurance
• To cover various administrative fees
• To increase cash value

The cash value of whole life insurance policy grows at a fixed rate determined by the insurer. With universal life insurance, you have control over how the cash value grows. The insurer allows you to select sub-investment accounts related to the cash value from a pool of limited possibilities. You may earn a higher rate of return with the right investments. But, if the sub-accounts you choose do not perform well, you may quickly lose the majority of your accumulated wealth.

Find the best rates

Compare quotes from Canada's top life insurance companies in no time.

Compare Rates

The cash value increases on a tax-deferred basis, which means you pay tax only when you withdraw it. This arrangement allows you to possibly save more money while paying less tax on investment gains.

Since it is your money, you (the policy owner) can access the policy's cash at any time. When you pass away, your beneficiaries only receive the death benefit, not the cash value.

The accumulated cash value can be accessed in the following ways:

Use it to secure a loan

You can borrow money using your life insurance policy as collateral assignment. If you default, the lender can claim your cash value as an asset.
The amount of money you can borrow by pledging the policy as security varies per lender. Nonetheless, you may be able to borrow up to 100% loan-to-value in some cases.

Using life insurance policy as loan collateral assignment can provide you with much-needed funds, but the practice is not without risks. For example:

If you can't repay a loan, the lender subtracts the balance from your policy's cash value, reducing the death benefit. Each withdrawal directly decreases the benefit. For example, with a policy of $1 million face value and $100,000 cash value, if you default on a $50,000 loan, the lender reduces the cash value accordingly, so your dependents would receive $950,000, not the original $1 million.

Generally, you can borrow against your insurance after it has been in place for a specified amount of time.

Take out a policy loan

A policy loan allows you to borrow money from the insurer while using the cash value of the policy as security. You can borrow no more than the current cash value of your policy. These loans are offered on permanent life insurance policies, such as whole life or universal life policies, that have enough cash worth to borrow against.

The insurer will charge you interest on the loaned amount, which may be more than the interest rate charged by standard secured loans. But, they differ from other types of loans in one important way: you are not compelled to repay the borrowed money.

A policy loan is simply an advance payment on the money you would receive if you surrender the policy. You can choose not to give back the money because it is money you would have received anyway. Nonetheless, the insurer will deduct the principal amount plus interest from the death benefit in that scenario.

In other words, if you do not repay, your beneficiaries will. The insurance will recoup the money it loaned you in some way.

Although they have higher interest rates than bank loans, they can still be a reasonable option in the following circumstances:

• You have a bad credit history
A bank performs a credit check before lending, making poor credit history a hurdle for approval. However, for a policy loan, there's no credit check due to its private nature and the insurer holding your money, thus, past credit isn't a concern.

• Quick approval
Getting a policy loan is really simple. Simply complete a one-page loan application to obtain the funds you require.

• Minimal financial requirements
Borrowing up to 90% of your cash worth is common, with sums as low as $1,000 being possible.

• Financial discretion
A policy loan does not appear on your credit report, or anyplace else.

Withdraw your cash value

You can withdraw money from your cash value account at any moment, but you will be charged a fee each time. Keep in mind that when you withdraw money from the cash value, the death benefit is reduced dollar for dollar. If you withdraw $50,000, your beneficiaries will receive $50,000 less after you die.

You can also withdraw the entire cash amount by surrendering the policy. In the insurance industry, "surrendering a policy" is synonymous with "cancelling it." When you surrender a permanent life insurance policy, you receive the net cash value (actual cash value minus surrender charges) and the policy expires. If you pass away, your beneficiaries will receive no monetary compensation.

How much money can you borrow against a life insurance policy?

In general, you can borrow up to 90% of the cash value of your insurance by using it as collateral assignment. When selecting how much money to borrow, a third-party lender would analyze your specific situation, such as your creditworthiness and the cash value growth rate.

What Are the Benefits of a Life Insurance Collateral Assignment?

A collateral assignment form of life insurance can assist you in getting a loan. Lenders frequently make it a prerequisite for a business loan. The bank knows that if you pledge your policy to get a loan, it will not lose money if you default or pass away before repaying it.

How does using my cash value as collateral work?

When using cash as collateral assignment for a loan, you must name the lender as an assignee. If you are unable to repay the loan, the lender can cash in the policy to reclaim the lent money or wait until you pass away to get a portion or all of the death benefit as payback of the debt.

Why use life insurance as loan collateral?

Assigning life insurance as collateral assignment allows you to secure a loan without committing property or assets to the lender. If you fall behind on your payments, you may lose your life insurance coverage, which, while undesirable, may not be as severe as losing your home. You can also purchase another life insurance policy to ensure that your family receives a payout to help them survive after you die.

Will the proceeds of a life insurance policy loan be taxed?

You can get money tax-free if you borrow from a third party lender and use life insurance as collateral assignment. But, if you get a life insurance loan from your insurer, you must pay tax on the portion of the borrowed amount that exceeds your policy's adjusted cost basis (ACB). The same is true of policy withdrawals.

A life insurance policy's ACB is the sum of premiums paid less the net cost of pure insurance. For example, say you have a perpetual life insurance policy and pay $4,000 in premiums each year. The net cost of pure insurance is $1,000, with $2,500 used to grow cash value and the remaining $5,000 used to keep the policy in force. In this situation, the ACB of your coverage is $3,000.

Example of Collateral Assignment of Life Insurance

Here's an illustration. Steve wants to create a web hosting company and requires a loan of $65,000 to do it. His bank agrees to lend him this sum in exchange for the assignment of his life insurance policy as collateral assignment. On his life insurance, which has a face value of $400,000 and a cash value of $80,000, Steve names the bank as an assignee.

This way, the lender is guaranteed that the money will be returned even if Steve defaults on the loan or dies before repaying it. Since the death benefit and cash value are greater than the loan amount, Steve's beneficiaries will get a payout after he passes away.

Alternatives to Collateral Assignment of Life Insurance

By assigning your life insurance as collateral assignment, you can secure a business loan (or a personal loan). If you are unable to make the loan payments, you risk losing coverage. If this occurs, your beneficiary will not receive the compensation you intended for them.

Other popular ways for getting a loan without the use of life insurance as collateral assignment include:

A Policy loan

The insurer will let you borrow against the cash value of your coverage. Policy loans are not subject to an income or credit check, and they are not taxed. But, this option is only available if you have a whole life or universal life insurance. Because term life insurance policies do not accumulate cash value, it cannot be used to get a life insurance loan.

Surrendering your life insurance policy

If you have a large cash value in your insurance, you can obtain it by surrendering the coverage. Nevertheless, once you do so, your coverage will terminate, and your beneficiaries will not get any death benefits if you die.

Home equity loan

A home equity loan is a sort of loan in which you borrow money against your house's equity. The difference between the current market value of your home and the outstanding mortgage is your home equity. If your home is currently worth $300,000 but you still owe $150,000 to your mortgage lender, you have $150,000 in equity.

Normally, you can borrow up to 85% of the value of your property. A home equity loan is a second mortgage that pays off the first mortgage's balance and then provides you the remaining funds.

Continuing with the above example:

1. You might borrow up to $240,000 (85% of the current value of your home, which is $300,000).
2. Because you still owe $150,000 on your first mortgage, you might finance up to $90,000 (keep in mind that home equity loan closing expenses normally vary between 2% and 5% of the loan amount).

Home Equity Line of Credit (HELOC)

Another way to access your home equity is through a HELOC. A HELOC is a secured line of credit that allows you to borrow money using your home equity as security on an as-needed basis.

HELOCs often offer lower interest rates than home equity loans, which means you may pay less interest over the life of the loan. These may be more difficult to manage, though, because neither the interest rate nor the monthly installment is fixed. A home equity loan, on the other hand, has a fixed interest rate and fixed monthly payments.

What Types of Life Insurance Can be used as Collateral?

There are two types of life insurance: term life and permanent life. Term life insurance covers you for a set amount of time and does not accumulate cash value. Permanent life insurance remains in place as long as you pay the premiums. Most permanent life policies (but not all) have a cash-value component.

Pick the right policy beneficiary

A common — and potentially costly — mistake is to name the lender as a beneficiary of their policy rather than an assignee. If you identify the lender as an assignee, the lender will receive the amount owed from the insurance proceeds, with the remainder going to your beneficiaries. If, on the other hand, the lender is the beneficiary, it will receive the entire death benefit, which could be substantially greater than the loan sum. Also, your heirs will not be compensated in this circumstance.

Is a life insurance policy loan risky?

You can get funds for your business or personal requirements by using life insurance as loan collateral assignment. But, there are some drawbacks to the relocation that you should be aware of.

The possibility of outliving your expected demise

Lenders base the loan amount not on your current cash, but on your estimated cash value at death, often allowing you to borrow up to 90% of it. However, if you live longer than anticipated, the lender might require early repayment or additional collateral assignment.

Interest rate and return rate assumptions

The lender sets your interest rate considering the cash value growth rate. However, if the interest rate increases or your cash value underperforms, they may request early repayment or additional collateral assignment.

Still, despite risks, loans financed by life insurance are popular and often favored over traditional secured loans, which utilize personal assets as security.

Using Permanent Life Insurance as Collateral

If you have a permanent life insurance policy, you can use its cash value as collateral assignment to secure a loan. Borrowing against your policy, however, is not without risks. If you cannot make your loan payments, your loved ones may receive a reduced death benefit or no money at all when you die.

At Dundas Life, we recognize that making financial decisions can be difficult. That is why our team of specialists is here to assist you in using your permanent life insurance policy as collateral assignment.

Reach out to us today to find out how we can assist you in weighing the risks and benefits and making an informed decision about your financial future.