How to borrow from your life insurance policy?

Life insurance in Canada plays a crucial role in financial planning, offering protection and potential long-term value. Understanding the main types of coverage, their features, and how they align with different financial strategies is essential before exploring more advanced uses, such as leveraging a policy for borrowing.

Term vs Permanent life insurance

Before diving into borrowing strategies, it’s important to understand the two broad types of life insurance available in Canada:

• Term life insurance — inexpensive, covers a fixed period (e.g., 10, 20, 30 years). Options at term expiry typically include cancelling, renewing (if the policy is renewable), or converting to permanent coverage (if convertible).
• Permanent life insurance — includes whole life and universal life, both of which build a living value inside the policy that can be accessed while the insured is alive. In whole life this is called the cash surrender value; in universal life it’s the investment account.

For most Canadians, using life insurance primarily as an investment is often less attractive than traditional vehicles like RRSPs or TFSAs. However, for certain high-income earners who have maximized other tax-advantaged accounts and who need advanced tax planning, permanent policies — and borrowing against them — can be a valuable tool.

Permanent policy mechanics: Whole life vs Universal life

Both permanent policy types accumulate value, but they behave differently:

• Whole life — insurer manages investments and credits a relatively stable cash surrender value. Lenders and the insurer can typically lend against up to ~90% of that value.
• Universal life — policyholder (with an advisor) chooses investment funds. Because of this variability, lenders usually require the invested funds to be in stable, fixed-income style allocations before they’ll advance loans up to the maximum percentage.

Three ways to access cash in a permanent policy

There are three primary methods to access the in‑policy value: surrender (full or partial), policy loans, and collateral loans. Each has distinct tax, credit, and risk characteristics.

1. Surrender the policy (full or partial)

Specification: surrendering means you give up part or all of the death benefit in exchange for cash surrender value.

• Full surrender: The policy is cancelled and the owner receives the cash surrender value. The death benefit disappears. Taxes apply on any amount in excess of the policy’s adjusted cost basis (ACB). Example: $1,000,000 face amount with $200,000 cash surrender value and $50,000 ACB — full surrender pays $200,000 but $150,000 (the excess over ACB) is taxable income in the year of surrender.
• Partial surrender: You reduce the face amount and receive a proportional portion of the cash surrender value. Taxation is pro‑rated: only the proportional excess over ACB is taxable.

Use case: partial surrenders can be useful when liquidity is needed but you don’t want to cancel the entire death benefit. Full surrenders are straightforward but often tax-inefficient.

2. Policy loan (loan from the insurer)

Specification: the insurer that issued the policy lends directly to the policy owner, using the policy’s cash value as the funding source.

• Interest rates: Typically in the range of ~4–7% in Canada (subject to current rate environment).
• Repayment options: You can repay interest monthly, or choose to capitalize the interest — that is, add unpaid interest to the loan principal so the loan and interest are paid from the death benefit when the insured dies.
• Credit and approval: Easier to get than a bank loan — the insurer generally does not require a credit check or debt service ratio analysis.
• Tax treatment (critical): Unlike the U.S., in Canada policy loans are considered a disposition for tax purposes. Any amount received that exceeds the policy’s ACB can be taxed as income. Early in a policy’s life the ACB may be low, but as premiums increase ACB changes — and in later years policy loans may trigger taxable income.
• Pros: Easy to access, flexible, no conventional credit approval needed, continues to allow the policy’s cash value to grow.
• Cons: Potentially taxable if loan proceeds exceed ACB; interest expense; capitalizing interest reduces the death benefit over time.

3. Collateral loan (third‑party lender)

Specification: a bank or other lending institution provides a loan secured by assigning the policy’s cash surrender value as collateral. The policy stays intact with the insurer, but the lender has a claim against the policy value.

• Interest rates: Generally comparable to policy loan rates (roughly 4–7% depending on market conditions and borrower risk).
• Tax treatment: For individuals in Canada (as of 2023), collateral loans are not treated as dispositions — they are generally non‑taxable regardless of ACB.
• Credit and approval: Lenders require good credit and capacity to service the debt. They will assess debt service ratios and may decline smaller loans. Many lenders consider anything under ~$250,000 to be a small amount and might be less willing to offer favorable terms; loan availability improves substantially at higher collateral levels (e.g., $500,000+).
• Pros: Typically tax‑efficient for individuals; preserves policy structure and cash value growth.
• Cons: Requires approval based on creditworthiness and income; may not be available or favorable for small policy values; lender may have stricter covenants.

Adjusted Cost Basis (ACB) — why it matters

ACB is central to taxation when accessing policy value in Canada. In simple terms:

• ACB increases as you pay premiums.
• ACB decreases over time as mortality cost (cost of insurance) is allocated against the policy.
• Policy loans are treated as dispositions — if the amount you receive exceeds the ACB, the excess becomes taxable income.
• Early loans may be tax-free; later loans may trigger tax depending on ACB and policy history.

Because ACB dynamics vary by policy and individual premium history, borrowers should review ACB with their insurer or advisor before taking loans.

Key pros and cons — quick product-style review

Pros

• Access to cash while retaining a permanent policy (with loans or collateralization).
• Policy loans are easy to obtain regardless of credit rating.
• Collateral loans can be tax-efficient for individuals (no disposition).
• Interest can be capitalized, allowing flexibility for borrowers who don’t want monthly payments.

Cons and risks

• Policy loans can be taxable in Canada if proceeds exceed ACB — critical difference from U.S. tax treatment.
• Capitalized interest reduces net death benefit; outstanding debt can erode policy value.
• If outstanding loans approach or exceed ~90% of cash surrender value and the value doesn’t recover, the insurer can require additional collateral, demand repayment, or cancel the policy (liquidate to repay the loan).
• Collateral loans require creditworthiness and may not be practical for small policy values.
• Corporate-owned policies have different tax rules and implications.

Who should consider borrowing from a life insurance policy?

• Good fit: High-income individuals who have maximized RRSP/TFSA vehicles, need additional tax planning or tax‑efficient liquidity, and have large permanent policy values (often $250k+ to access the best collateral loan terms).
• Use with caution: Individuals early in their policy with low ACB need to consider tax consequences of policy loans; those with limited credit or small policy values may struggle to obtain favorable collateral loans.
• Not ideal: Most Canadians looking for pure investment returns will usually do better with RRSPs, TFSAs, or other investment accounts rather than using permanent life primarily as an investment vehicle.

Practical tips and planning considerations

• Always confirm current interest rates and loan terms with the insurer and with potential lenders.
• Request a policy illustration that shows the effect of capitalizing interest on the death benefit and cash surrender value over time.
• Check your policy’s ACB history to understand potential tax consequences before taking a policy loan.
• If pursuing a collateral loan, shop lenders and target a policy with a larger cash surrender value (many lenders become more competitive above ~$250k–$500k collateral).
• Plan for worst-case scenarios: if cash surrender value decreases or loan interest compounds, ensure there is a plan to repay or provide additional collateral to avoid policy lapse.
• For corporate-owned policies, tax rules differ significantly — consult a tax advisor or request specialized guidance.

Overall recommendation

Borrowing from a permanent life insurance policy can be a powerful and flexible tool when used properly — especially for high-income Canadians who need tax-efficient liquidity beyond RRSPs and TFSAs. However, it requires careful planning: understand ACB, compare policy loans versus collateral loans, account for interest (and whether it will be capitalized), and be aware of lender requirements and policy‑lapse risk if loans approach the policy’s available value.

For most Canadians the strategy is not necessary; for the minority with high incomes, significant policy values, and sophisticated tax planning needs, borrowing against a life policy can make sense. Always consult a qualified insurance specialist and a tax advisor to model the outcomes before proceeding.

Next steps

• Review your policy illustration for cash surrender value and ACB history.
• Speak with an insurer or independent advisor to get current policy loan rates and collateral loan options.
• If corporate strategies are relevant, request professional tax and legal advice — the rules are different for corporations.