After the Policy Loan: The First Thirty Days

The money arrives in a few business days. No credit check came before it, no lender sent a payment calendar with it, and nobody will call if you miss a month. That is exactly the moment many families stop paying attention.

It should be the moment they start.

A policy loan puts you in an unusual position. You owe a real debt to a large financial institution, the insurer, and the insurer leaves the pace of repayment almost entirely to you. That freedom can serve a household well, especially one whose income arrives unevenly. It can also let a balance grow quietly for years, until the loan meets the cash value that secures it. What decides between the two outcomes is rarely the insurer's behaviour. It is what the family does in the first month.

Here is what that month can look like, step by step.

What changes the day a policy loan is paid out?

From that day you owe the insurer money, secured by your policy's cash value. Interest starts at once, the amount you can still borrow falls, and the death benefit your family would receive is reduced by whatever remains owing. None of this requires a repayment schedule, which is why you need your own.

The Income Tax Act describes a policy loan as an amount advanced by an insurer to a policyholder in accordance with the terms of the policy. The words matter. The money is the insurer's, advanced from its general funds. It is not your cash value leaving the policy, and it is not money you lend to yourself. The cash value stays inside the contract as security.

So three things change at once. First, interest is charged on the balance, usually calculated daily from the date of the loan. Second, the amount you can borrow next time is smaller, because the loan and its interest are subtracted from the loan value. Third, if the life insured died tomorrow, the insurer would deduct the balance and accrued interest from the death benefit before paying your beneficiaries.

What does not change is just as important. The premiums are still due. If your contract has a premium to pay, the loan does not pay it. The guarantees in the contract still depend on the policy staying in force. And the purchase you made with the money, a vehicle, a repair, an opportunity, carries on with its own life, which usually includes losing value.

Some presenters describe repayment as "guaranteed" because the insurer will always collect, one way or another. That is true only in a narrow sense, and it hides the risk. The insurer collects from the death benefit, from the surrender value, or by letting the contract lapse when the debt reaches the cash value. Each of those is a cost to your family. The insurer is protected. Your coverage is not.

What should you read on the insurer's loan confirmation?

Read five things: the amount advanced, the interest rate and whether it can change, how and when interest is charged and added to the loan, how payments will be applied, and the loan value still available. If the confirmation does not state one of them, ask the insurer in writing.

Most families file the confirmation without reading it. It is the shortest document that will matter for years, so give it ten minutes.

The amount and the date. Check that the amount matches your request and note the date. Interest runs from that date.

The rate. Policy loan rates are set by the insurer, not negotiated. In at least one Canadian insurer's published terms, the rate can be changed at any time, and a new rate applies to the balance already outstanding. A rate is not a promise for the life of the loan unless your contract says it is fixed.

How interest is charged. Many presenters call policy loan interest "simple interest". That is accurate within a policy year and incomplete across years. In many Canadian participating contracts, interest accrues daily and any amount not paid by the policy anniversary is added to the loan. From the next day, interest is charged on the larger balance. That is compounding, once a year.

How payments are applied. Find out what happens to money you send. One Canadian insurer applies a payment that arrives without instructions to any unpaid premium first. Others apply loan payments to interest before principal, or to principal with unpaid interest capitalized later. You need to know which, because it decides what your payment actually does.

What remains available. The confirmation or your next statement should show the loan value still available. That figure, not the gross cash value, is what you can rely on for the next need.

If your contract or confirmation is unclear on any of these, a short written question to the insurer is worth more than an assumption. Keep the answer with the policy.

How do you write a repayment plan that will actually be kept?

Answer three questions on paper: what the money was for, where each payment will come from, and what you will do if a payment cannot be made. Then set the amount, the day of the month and the end date, and treat them as terms an outside lender had set.

The first question looks backwards, and it is still useful. Writing down what the money paid for keeps the loan attached to a purpose. A loan with a purpose tends to get repaid. A loan that has drifted into general spending tends to be refinanced by the next loan.

The second question is the one most plans skip. "From our surplus" is not an answer. Name the source: a monthly amount from salary, a seasonal amount from a business that earns most of its income in some months, a bonus, a tax refund, rent from a property. Then test it against an ordinary month, not a good one. If the payment only works when nothing else goes wrong, it is too large.

The third question protects the plan from the first surprise. Decide in advance what happens if income stops for a few months. Perhaps you will pay the interest only for a set period, then resume. Perhaps you will extend the end date by the number of missed months. Writing the fallback now prevents the common pattern, where one missed payment quietly becomes no plan at all.

Then put the plan in numbers: the monthly amount, the payment date, the date you expect the balance to reach zero, and the date you will review it. Our page on thinking like a lender shows how to keep a written ledger of each advance and repayment, and our one-page family financing plan shows where the loan fits among the household's other commitments.

One more decision belongs in the plan: the pace. Nelson Nash taught that a family should repay its policy loans at least as seriously as it would repay an outside lender, and some practitioners suggest repaying at the rate a car lender would charge rather than at the insurer's lower rate. Here is what that does and does not do. Paying more reduces the loan sooner and cuts the interest you pay. It does not turn the extra into a premium. A loan payment reduces the loan. Money sent as a premium or as an additional deposit is a separate payment, made within the contract's limits and the exempt test, and only if you send it as such.

How do you set up the payments?

Use a method the insurer accepts and that labels each payment as a loan repayment, ideally a pre-authorized debit on a fixed date. Confirm in writing how the insurer applies it, and check the first two statements to see that the balance fell as expected.

Insurers differ in what they accept. One Canadian insurer's published terms allow loan repayments at any time by pre-authorized debit, cheque or online payment, and do not accept credit cards. Others have their own lists and minimum amounts. Ask what your insurer accepts and whether the payment can be set up as a recurring loan repayment rather than a one-off.

Automation does the work that a lender's reminder letter would otherwise do. A payment that leaves the chequing account on the same day each month, a few days after income arrives, is far more likely to continue than a payment that depends on remembering. If your income is seasonal, the automation can follow the season: larger payments in the strong months, interest only in the slow ones, as long as the plan says so in advance.

The label matters as much as the method. If a payment is applied to an unpaid premium, or held as an unallocated amount, your loan does not fall and your next statement will look wrong. Keep each confirmation, and compare it with the loan balance on the next statement.

If a pre-authorized payment is ever returned for lack of funds, call the insurer that week. Find out whether the payment can be re-run, and check that the premium, which may come from the same account, was not affected as well.

What happens on the policy anniversary?

In many contracts, any interest not paid during the policy year is added to the loan on the anniversary, and interest is then charged on the larger balance. A loan left untouched therefore grows faster each year, and it can reach the cash value sooner than families expect.

Write the anniversary date in the calendar now, not when the annual statement arrives. It is the day the loan's arithmetic changes.

Here is a hypothetical example, computed for this page. It assumes a $20,000 policy loan at 7% a year, with unpaid interest added once a year on the anniversary. It is not a quote or any insurer's rate.

After three years without payments, the family owes $4,500.86 more than it borrowed, and the loan value available for the next need has fallen by the same amount. Paying only the interest holds the balance level. Paying more than the interest brings it down. The rate in your contract, and how it is applied, will produce different figures, but the pattern is the same.

Many families pay little attention to this because their cash value grows each year as well. It may. Growth in the cash value comes from premiums, the contract's guarantees and, if declared, dividends. It does not come from your loan. Comparing the two growth rates is the subject of our page on policy loan interest against dividends. For the first month, the practical point is simpler: know the date, and decide before it arrives whether you will have paid at least the year's interest.

Does the loan create tax, and who needs to know?

It can. A policy loan is a disposition under the Income Tax Act, so any part of it above the policy's adjusted cost basis is income in the year of the loan. Your accountant also needs to know whether the money was used to earn income, because that decides whether the interest can be deducted.

Three tax facts are worth knowing in the first month.

The loan itself. If the loan exceeds the policy's adjusted cost basis, the excess is a policy gain, taxable in the year of the loan and reported on a tax slip by the insurer. Below the adjusted cost basis there is no tax on the loan, but the basis falls by the amount borrowed. Our page on when a policy loan becomes taxable walks through the calculation.

The repayments. Repayments generally add back to the adjusted cost basis, within limits in the Act. Where part of the loan was taxed, the Canada Revenue Agency has explained that later repayments can be deducted under paragraph 60(s), up to the amount previously included in income, in the year the repayment is made. The deduction cannot be carried to another year, which makes the timing of repayments a question worth asking your accountant.

The interest. Interest on a policy loan used to earn income from a business or property can be deductible under the ordinary rules. The insurer completes form T2210, Verification of Policy Loan Interest by the Insurer, to support the claim. Interest on a loan used for a personal purchase is not deductible. Interest that is not deducted is treated as a premium in the adjusted cost basis calculation.

So the first-month task is short: tell your accountant the amount, the date, the purpose of the money and the policy's adjusted cost basis before the loan, which the insurer can provide. Ask the insurer when and how it will report the loan.

Which numbers should you watch from now on?

Watch two: the net cash value, which is the cash value less the loan and accrued interest, and the net death benefit, which is the death benefit less the same amounts. The first tells you how close the policy is to lapse. The second tells you what your family would actually receive.

The gross cash value on a statement can look reassuring while the net figure shrinks. Compute the net figure each time a statement arrives, and keep the results on one line in your ledger, year after year. A net cash value that falls two years in a row is a signal to revise the plan.

The net death benefit deserves the same attention, because the death benefit is the reason the policy exists. A family that needed $500,000 of protection and now has a $60,000 loan has $440,000 of protection. If that gap matters, the repayment plan is also a protection plan.

Ask the insurer one more question in the first month: how does an outstanding loan affect the dividends on this contract? Some participating contracts adjust the dividend on the portion of the cash value that secures a loan, and others do not. An in-force illustration that includes the loan will show the effect, and it is the right document to keep beside your plan. Dividends are not guaranteed in either case.

What does the first month look like as a checklist?

On the first day, read the confirmation. In the first week, write the plan and tell your accountant. By the end of the month, the payments run automatically, the anniversary is in the calendar and the net figures are recorded.

A family that does these eight things has turned a loan without terms into a loan with terms, set by itself. That is the habit at the heart of the approach Nelson Nash described, and it matters more than the size of the policy.

What this page will not tell you

It will not tell you your own figures. Loan rates, the way interest is charged, how payments are applied, minimum amounts and the effect of a loan on dividends all differ between insurers and between contracts. Read your contract, and ask the insurer in writing where it is unclear.

It will not tell you whether to borrow. A policy loan is a debt with a cost, and for some purchases cash, waiting or an outside lender will cost less. Our page on deciding what the system should finance covers that decision.

It will not give you tax advice. The rules above are general. Your accountant should confirm the treatment of your loan, your repayments and your interest, using the figures the insurer provides.

And it does not describe a way to get something for nothing. The insurer earns the interest. Your family gains the use of the money, the flexibility of the terms and, if the plan is kept, the restored capacity to borrow again.

Who this does not suit

A policy loan without a written plan does not suit a household whose budget has no room for a payment in an ordinary month. If paying the loan would mean missing a premium, drawing down the emergency reserve or carrying a credit card balance, the loan is likely to grow rather than shrink.

It does not suit a family that needs every dollar of its death benefit. A balance left outstanding reduces what the beneficiaries receive, and a family that bought coverage to replace an income may not be able to afford that reduction.

And it does not suit anyone who expects the policy to repay the loan by itself. The cash value may grow, and dividends may be paid, but neither pays the loan. Only payments do, or, eventually, the death benefit or the surrender value, at a cost to your family.

If you would like to talk through a plan for a loan you have already taken, or one you are considering, we invite you to request a discovery meeting. We will look at your contract's terms with you, and we will tell you plainly where a loan does not fit.