How To Use Life Insurance While Alive In Canada
Life insurance is an important tool that helps you protect your loved ones from financial distress if you die.
There are also advantages to life insurance beyond the death benefit. If you have a policy with a cash value component, you can borrow money from your life insurance.
Cash value life insurance can be one of the most convenient, low-cost financing options out there. But there are also pitfalls to avoid if you go this route.
Most permanent life insurance policies offer the opportunity to borrow money from the cash value.
Permanent life insurance (including whole life, universal life and variable life) is designed to provide coverage for your lifetime.
Permanent life policies build cash value as you pay the premiums. The cash value portion of the policy either earns interest or is tied to an investment account or index, allowing you to grow the money over time.
Term life insurance, by comparison, is not life insurance you can borrow from. Term life insurance is a fairly low-cost insurance option designed to protect people during the years they need it most, such as the working years until their mortgage is paid off. These policies do not have a cash value component.
How Does a Life Insurance Policy Loan Work?
Policy loans come in the form of direct loans or indirect automatic premium loans, according to Barry Flagg, founder of Veralytic, an independent life insurance analytics company.
Direct loans
With a direct loan, you essentially borrow money from yourself, with the policy’s cash value serving as collateral. For this reason, you don’t have to pay income tax on the money you take out. The insurance company will also charge interest (called a spread).
Flagg explains that you essentially pay the interest back to yourself, less a spread charged by the insurance company. Usually, this can be as little as 0.25% (even 0% in some cases) or as much as 2%.
“Choosing a policy with a low loan spread can make a big difference,” Flagg says. “Either way, policy loans reduce both the policy account value and the death benefit by the amount of the loan on a dollar-for-dollar basis.”
If you pay the policy loan before you pass away, there is no deduction from the death benefit.
Automatic premium loans
An automatic premium loan (APL) allows the insurer to use your cash value to pay your life insurance premiums, if you don’t.
“While insurers generally send notice of such automatic premium loans, consumers don’t often understand the implications,” Flagg says. “So this type of policy loan can unwittingly accumulate for years.”
Flagg says that interest is also added to the balance, often at unfavorable rates. So when policyholders aren’t aware of these implications, APLs can grow quite large, eroding the cash value and causing a policy lapse.
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