Policy loans and using a policy as collateral

What you can borrow against

Only cash value. That means a permanent policy that has been in force long enough to build some.

Term policies have no cash value and never will. Term to 100 usually has none either. A whole life or universal life policy in its first few years may have very little, because early premiums go to the cost of insurance and to setting the policy up. See cash value and how it builds.

Before assuming this is available, check the current cash surrender value on your annual statement.

Two different routes

A policy loan comes from the insurer. You ask, and they advance money secured against the cash value of your own policy. There is no credit check and no approval process, because you are borrowing against an asset they already hold. It is usually available within days.

A collateral assignment means borrowing from a bank, with the policy formally pledged to the lender as security. The insurer is not lending you anything. The lender does its normal assessment, and if it approves, the policy sits behind the loan.

They look similar from the outside and behave quite differently.

Policy loans in practice

The cash value does not leave the policy. It stays where it is, and the loan sits against it.

The insurer charges interest, at a rate set out in the contract. If you do not pay that interest, it is added to the loan balance, and the balance compounds.

Two consequences follow. Any outstanding loan plus accrued interest is deducted from the death benefit when you die, so your beneficiary receives less. And if the loan grows until it approaches the cash value, the policy can lapse. A lapse in that situation is worse than it sounds, because it can trigger a taxable disposition at exactly the point you have no money to pay the tax.

There is also a tax consideration at the start. A policy loan is not automatically tax free. Where the amount advanced exceeds the policy’s adjusted cost basis, part of it is included in income. How much depends on the policy’s history, including dividends credited and any prior withdrawals. See tax on cash value and policy loans.

Collateral assignment in practice

The tax position is usually the reason people prefer this route. Borrowing from a bank is borrowing, not a disposition of an interest in a policy, so it does not create the same income inclusion a policy loan can.

The bank sets the rate, which may be better or worse than the insurer’s. It also decides how much it will lend against the cash value, typically a percentage rather than the full amount, and it can require the policy to be maintained.

The practical constraint is that not every lender will do this, and not every policy is attractive as security. Small policies and policies with modest guaranteed values often are not.

When it makes sense

Short-term liquidity where the alternative is worse. Someone with a temporary cash need who would otherwise take on high-interest debt may be better off borrowing against a policy they intend to keep.

Business cash flow, for a corporately owned policy, where a collateral assignment can fund a short-term need without disturbing the coverage.

A retirement income strategy, where an established policy with substantial cash value is used to supplement income through borrowing rather than withdrawal. This depends on a lender, on the policy having genuine size, and on advice from an accountant. It is not something to improvise.

When it does not

As a substitute for saving. Borrowing against a policy costs interest and shrinks the death benefit. It is not free money, whatever the pitch says.

Early in a policy’s life. There is rarely enough cash value for it to be worth the paperwork, and the tax treatment is least favourable when the adjusted cost basis is high relative to the value.

When repayment is unlikely. An unrepaid loan compounding for twenty years can consume much of the death benefit and can eventually put the policy at risk. That is the opposite of what the policy was bought for.

Before you borrow

Ask the insurer for four figures in writing: the current cash surrender value, the maximum they will advance, the loan interest rate, and how much of the advance would be taxable.

That last one is the number people do not think to ask for, and it is the one most likely to produce an unpleasant surprise the following spring. It is also a question worth putting to an accountant rather than relying on a general answer.