Is It a Good Idea to Take a Loan Against Your Life Insurance Policy? Seven Questions Before You Borrow

You need money for something real. A car, a roof, a business expense, a down payment. And you remember that your life insurance has a cash value, and that you can borrow against it. The question that follows is the one people now type into Google, word for word: is that a good idea?

Why does this matter to you? Because the answer is not the same for everyone, or even for the same person at two different times. The same policy loan can be a sensible way to pay for a planned purchase in one year, and a slow way to weaken a contract in another. What changes is the age of the contract, the purpose of the money, and whether you will actually pay it back.

So this page does not argue for borrowing or against it. It explains what a policy loan is, when it tends to suit and when it tends not to, and the seven questions worth answering before you sign the request. You will leave knowing what to ask, and of whom.

Here is the short answer.

Is it a good idea to take a loan against your life insurance policy?

It can be, when three things are true: the contract has built enough cash value, you have a realistic plan to repay from your own income, and the purpose is one you would otherwise finance with a lender. It is a poor idea early in a contract, for everyday spending with no repayment source, or when your family needs the full death benefit.

That answer has three conditions, and each one matters. A loan against a young contract borrows against very little. A loan with no repayment plan quietly grows, because the interest is added to what you owe. And a loan taken when the family depends on every dollar of the death benefit reduces the amount they would receive.

None of this makes a policy loan good or bad in itself. It is a tool. The tests below tell you whether it is the right tool for the job in front of you.

What actually happens when you take a policy loan?

The insurer advances you money from its own funds, with the cash value of your policy as security. You owe the insurer, you pay interest to the insurer, and anything still owing at death is subtracted from the death benefit.

The Autorité des marchés financiers, Quebec's regulator, describes it plainly. A policy loan means borrowing with your insurance, that is its cash value, as security. Because it is a loan, you must ultimately repay the sums borrowed and pay interest on them. If you die before the repayment is finished, the insurer subtracts what you owed, and the interest that built up, from the amount of insurance it pays.

The AMF gives its own example, which is worth reading slowly. A policy has $100,000 of coverage and a cash value of $15,000. The owner borrows $7,000. Some years later the owner dies, and $2,000 of interest has built up on the loan. The insurer pays $91,000: the $100,000, less the $7,000 loan, less the $2,000 of interest. The figures are the regulator's illustration, not a projection for any contract.

Three points follow from that description. First, the money does not come out of your cash value. It is the insurer's money, lent to you, and your cash value stands behind it as security. That is why the method we teach treats the insurer as the lender, and never describes a policy loan as spending your own money. Second, the interest is real and it is paid to the insurer. Third, the loan has a natural end: either you repay it, or it is settled out of the death benefit.

The Income Tax Act uses the same idea. Subsection 148(9) defines a policy loan as an amount advanced by an insurer to a policyholder under the terms of the policy. Our page on policy loans in Canada walks through the mechanics in full.

When does a policy loan tend to make sense?

A policy loan tends to suit a purchase you planned, of a size the cash value can comfortably secure, on a contract past its early years, with a repayment schedule you can keep from your own income.

Think about how most families pay for a large purchase. They save for it, or they finance it with a lender. When they finance it, the lender checks their credit, sets the schedule and collects the interest. A policy loan changes some of that. The insurer usually asks for no credit application, because the cash value secures the advance. You set the schedule. The interest still goes to a lender, but that lender is the insurer that holds your contract.

That is the use the method was built around: financing the purchases you would otherwise finance elsewhere, and then repaying them as you would repay any lender. Our page on what a policy is for, stage by stage explains why that order matters.

A policy loan also tends to suit someone who values the access more than the rate. The money can usually be requested without explaining what it is for. It does not depend on your credit score that month. For a business owner with uneven income, or a family facing a purchase that a lender would be slow to approve, that access can matter.

Here is the condition that sits under all of it. The contract has to keep going. The premiums have to be paid, and the loan has to be repaid. A policy loan that works is one where, a few years later, the loan is gone and the contract is still growing.

When is a policy loan a poor choice?

A policy loan is usually a poor choice early in a contract, for spending with no repayment source, to keep a premium going that you can no longer afford, or when your family would need the full death benefit.

Start with the early years. In the first years of a contract, the cash value is lower than the premiums paid, because the cost of issuing the policy and the cost of insurance weigh most at the start. There is little to borrow against. And a loan taken then can slow the very thing the contract needs most in those years, which is time. Our page on borrowing against a new policy works through that arithmetic honestly.

Then there is the loan with no plan to repay. The insurer usually does not send you a bill. That feels like freedom. It is also the risk. Unpaid interest is added to the balance. The balance grows. If the loan and its interest grow larger than the cash value allows, the contract can end, and the end can bring tax. A loan nobody repays is not flexible. It is just slow.

Everyday spending deserves its own warning. Groceries and utilities come back every month. If they are paid with policy loans and nothing is paid back, the balance has nowhere to go but up.

And there is the family. A policy loan reduces what is paid at death by whatever is still owing. If your spouse or your children depend on every dollar of that coverage, a loan reduces their protection while it is outstanding. So know that figure before you borrow.

What are the seven questions to answer before you borrow?

Before you take a policy loan, answer seven questions in writing: what the money is for, how you will repay it, how much the contract can lend today, what it will cost, what it does to the death benefit, how it is taxed, and what a lender would charge instead.

Here they are, in the order we suggest you answer them.

1. What is the money for, and would I otherwise finance it with a lender?
2. Where will each repayment come from, and on what schedule?
3. How much can the contract lend today, after any loan already owing?
4. What interest rate applies, how is it charged, and can it change?
5. By how much would the death benefit fall if I died with this loan outstanding?
6. What is my adjusted cost basis, and would this loan exceed it?
7. What would another lender charge for the same amount over the same period?

The first two questions are about you. Nobody else can answer them. The next four are about your contract, and the insurer can answer them for your policy, today, in writing. The last one is about the alternative, and it keeps the comparison honest.

If you can answer all seven clearly, you are deciding. If two or three stay blank, you are guessing, and the request can wait a week.

Where does the repayment come from?

The repayment should come from your own income, on a schedule you set before you borrow and keep afterwards, as you would repay any lender.

This is the question that decides most of the others, which is why it comes second. A policy loan has no fixed schedule unless you give it one. So give it one. Decide the monthly amount, the start date and the end date before you send the request. Then treat the payment the way you would treat a car loan from any lender.

What should a repayment not come from? It should not come from the policy dividends taken in cash. In the method we teach, dividends stay in the policy to buy paid-up additions, and the extra deposit option is used every year. Taking dividends in cash to service a loan slows the contract's future growth to pay a debt that your income should pay. Dividends are not guaranteed; a lower dividend slows future growth but does not reduce cash value already credited. Yet the Canadian insurers we work with have paid them every year for generations, as you will see further down this page.

When you repay, the amount you can borrow again is restored, and so is the death benefit the loan had reduced. Our page on what repaying a policy loan really gains shows the effect on your net worth, line by line. And our page on the first thirty days after a policy loan sets out the habits that make a schedule stick.

How does a policy loan compare with a loan from another lender?

Compare the interest rate, how it is charged, the total cost over the same period, the effect on the death benefit and the tax treatment. A policy loan usually needs no credit application and has no fixed schedule; a lender's loan usually depends on your credit and requires regular payments.

Comparisons go wrong when they compare a rate with a feeling. So compare like with like. Take the same amount, over the same number of years, with the same repayment, and put the two side by side.

On the policy loan side, the insurer sets the interest rate, often once a year, and may change it. Interest is usually charged once a year, and any interest you do not pay is added to the balance. The loan does not depend on your credit score, and it does not need a lender's approval of your income. Whether an outstanding loan changes the dividend your contract receives depends on how the contract is designed; our page on policy loan interest and dividends explains the difference, and the insurer can confirm the treatment for your own contract in writing.

On the lender's side, the rate depends on your credit, your income and the security you offer. Payments are usually fixed. The lender may also take your policy itself as collateral, which is a different arrangement. The AMF notes that you could borrow from another financial institution with your insurance as security. Under subsection 148(9), assigning a policy to secure a loan other than a policy loan is not a disposition, so it is taxed differently from a policy loan. Our page on a policy loan and other credit sets the options out together.

Neither choice is better in every case. The right one is the one whose full cost, over the full period, you understand before you sign.

How is a policy loan taxed in Canada?

A policy loan is a disposition under subsection 148(9) of the Income Tax Act. In general, the part of the loan that exceeds the policy's adjusted cost basis is included in income; a loan within the adjusted cost basis is generally not taxed.

The adjusted cost basis is, in broad terms, what the Act treats as your cost in the policy. It generally rises with premiums paid and falls over the years with the cost of insurance. On many older contracts it is lower than the cash value, which is why a large loan on an older contract can create a taxable amount. Our page on when a policy loan becomes taxable explains how the gain is calculated.

Two further points from the Act are worth knowing. The definition of premium includes interest paid to the insurer on a policy loan, other than interest that was deducted. And the tax treatment of the interest itself, including whether any of it can be deducted, depends on what the borrowed money is used for. Both are questions for your accountant, with your own figures.

So before you borrow, ask the insurer for the adjusted cost basis of your policy as at the date of the loan. Then ask your accountant what the loan would do to your tax return. A few minutes on the telephone can prevent a surprise in April.

How much can you borrow from a $10,000 life insurance policy?

Not $10,000. The $10,000 is the death benefit. A policy loan is limited to the share of the cash surrender value that the contract allows, less any loan and interest already owing, and a term policy has no cash value at all.

People often ask this question with a specific face amount in mind: $10,000, $100,000, $500,000. The face amount tells you what the insurer pays at death. It does not tell you what the contract can lend. That figure comes from the cash surrender value, which depends on the age of the contract, the premiums paid, the dividends credited and any loan already outstanding.

A small permanent policy that has been in force for many years may have a useful cash value. A large one that was bought last year may have very little. And a term policy, however large, has no cash value and cannot be borrowed against. Our page on borrowing against a $500,000 policy works through the same question at a larger size, and our page on reading the cash value table shows where the figure appears.

The simplest step is the most reliable one. Find your latest annual statement, or call the insurer, and ask for the maximum loan available on your policy today.

What does a well-designed contract change?

A specially designed, high-cash-value, participating whole life insurance policy is built so that more of the early premiums go to cash value. That gives a policy loan something to rest on sooner, but it does not remove the need to repay.

The design of the contract decides much of what a loan can do. A contract designed for high cash value, with the extra deposit option used every year, builds the value that secures a loan faster than a contract designed only for the death benefit. That is why the method begins with design, years before the first loan. Our whole life insurance section gathers the pages on how such a contract is built.

It does not change the rules above. A well-designed contract still needs its premiums paid. A loan against it still carries interest paid to the insurer. And a loan nobody repays still grows. Design gives you room. Discipline decides what you do with it.

Participating whole life insurance is life insurance. It is not an investment, and a policy loan is not a return on anything. It is credit, secured by a value that took years to build.

What should you ask the insurer in writing?

Ask for the maximum loan available today, the interest rate and how it is charged, the adjusted cost basis, the death benefit net of the loan, and what happens if the balance approaches the cash value. Ask for every answer in writing.

Here are the questions to bring to the insurer, or to the licensed insurance professional who placed your contract:

1. What is the maximum loan available on my policy today, after any loan already owing?
2. What is the current interest rate, how often is it charged, and how often can it change?
3. What is my adjusted cost basis as at the date of this loan?
4. What would the death benefit be, net of this loan, if I died next month?
5. Does an outstanding loan change the dividend my contract receives?
6. At what point would the balance and interest put the contract at risk, and how will you warn me?

Then take the answers to your accountant before you send the request. A professional who answers each of these clearly, and in writing, is one you can rely on.

What this page will not tell you

It will not tell you whether to borrow. That depends on your income, your family, the purpose of the money and the terms of your own contract. You decide it with a licensed insurance professional and your accountant. This page gives no figure for any contract's cash value, loan maximum, interest rate or dividend. Each one belongs to one contract and appears in its statement or illustration. The figures in the AMF example are the regulator's own illustration. This page gives no tax or legal advice. The tax points above are general rules, and how they apply to you is a question for your accountant. The base of the policy is guaranteed: the cash value and the death benefit are written into your contract, year by year. The dividend is the part that is not guaranteed, and here the history is reassuring. Canada Life has distributed dividends to its participating policyowners every year since 1848, Sun Life has declared them every year since 1877, and Equitable Life of Canada has paid them every year since it began offering participating insurance in 1936. A long record is not a promise about the future, and once a dividend is credited to your policy, it stays credited.

Who this does not suit

A policy loan does not suit someone who has no realistic way to repay it. It does not suit a contract in its early years, when the cash value is still below the premiums paid. It does not suit someone who needs the full death benefit to stay in place for a family that depends on it. And it does not suit anyone looking for a way to spend without a schedule, because the interest keeps adding up whether or not anyone is watching.

If one of those describes you today, the honest answer is not yet. Knowing how a policy loan works is still worth the time, whatever you decide.