Borrowing against your life insurance policy in Canada: Limits, tax & risks

The concept of borrowing against your life insurance policy in Canada, often called ‘infinite banking,’ has gained traction on social media. On TikTok alone, the hashtag has amassed over 110 million views, with many financial influencers highlighting its advantages.

The idea is that borrowing from your policy’s cash value can offer a financial safety net and let you benefit from your policy during your lifetime. Using your life insurance policy as collateral for a loan or purchasing a policy to borrow against it might appear to be a straightforward financial fix. However, the process is often complex, and missteps could jeopardize your policy. 

This guide explains how much you can borrow, when loans are taxable, and what happens to your death benefit if you never repay. By the end, you’ll know when this strategy fits your plan, and when to avoid it.

What is a life insurance loan?

A life insurance policy loan enables you to access funds by borrowing against the cash value of a permanent life insurance policy, such as whole life or universal life insurance. If you have held a whole or universal life policy for several years and it has accumulated sufficient cash value, you may be eligible to take out a loan against it.

Basic terms you need to know:

Cash Value

The accumulated savings or investment portion of your permanent life insurance policy. It grows over time as you pay premiums and earn interest or dividends, depending on your policy type. This is the amount you are borrowing against.

Surrender Value

The cash value minus any surrender charges (fees for canceling the policy early). If you cancel the policy, the surrender value is the amount you receive after these charges are deducted.

How borrowing works

In Canada, borrowing against a life insurance policy is an option exclusively available to individuals with permanent life insurance policies with cash value. Term life insurance cannot be used for this type of loan. Eligibility for borrowing depends on the amount of cash value accumulated within the policy. When you borrow against your policy, the insurer uses the cash value as collateral. Therefore, the policy must have accumulated sufficient cash value over time, which usually requires several years of premium payments.

Generally, you can borrow up to 90% of your policy’s cash value, though the exact percentage may differ based on the insurer’s specific terms. This loan option allows the policy to stay active, provided that other conditions, such as paying interest, are fulfilled.

Interest rates

• The interest on the loan can be fixed or variable, depending on the insurance company’s policy. Fixed rates provide consistent payments, while variable rates may fluctuate based on market conditions.
• Interest starts accruing immediately and is either added to the loan balance or deducted from the policy’s remaining cash value.

Repayment terms

• There is no mandatory repayment schedule for the loan. You can repay it at your convenience, whether through periodic payments or in a lump sum.
• If you choose not to repay, the outstanding loan balance and accrued interest will be deducted from the death benefit payable to your beneficiaries upon your passing.

Surrendering the policy

If you were to cancel the policy entirely, you would receive the surrender value. However, if you cancel a life insurance policy after borrowing against it, you will receive the surrender value minus the outstanding loan balance and any accrued interest. Here’s how it works:

Calculation example

• Surrender Value: The amount you’d receive if you cancel the policy (cash value minus surrender charges, if any).
• Loan Balance: The total amount borrowed against the policy, including any unpaid interest.
• Final Payout: 

Key Points to remember

• You may receive nothing if the loan balance and interest exceed the cash value, and the policy could lapse. This could leave you without coverage and trigger potential tax consequences.
• Canceling a policy with an outstanding loan can also result in taxable income if the loan exceeds the policy’s adjusted cost base (ACB).

To maximize your payout and avoid surprises, you should monitor loan balances and consider repaying or reducing the loan before canceling the policy.

What is ACB and why does it matter for policy loans?

ACB stands for Adjusted Cost Basis (ACB), and it is the tax “cost” of your policy. It starts with premiums paid and is adjusted over time (reduced by the net cost of pure insurance and certain benefits, and affected by dividends/transactions).

ACB matters because tax on surrender or lapse is based on proceeds minus ACB. With loans, if your policy lapses and the outstanding loan is effectively relieved, that relief counts in proceeds. If proceeds exceed ACB, the excess is taxable. A low ACB late in life plus a large loan can create an unexpected taxable gain.

Action steps: request an ACB summary from your insurer, track loan growth, avoid borrowing to the edge, and review with your advisor before changing dividend options, reducing coverage, or making withdrawals that might lower ACB further.

Associated risks

Borrowing against your life insurance policy in Canada doesn’t require collateral like your home or car; the policy’s cash value serves as security for the loan. Loans against life insurance policies are typically tax-free since they are considered borrowing rather than income.

If you choose not to repay the loan, the outstanding balance, including accrued interest, will be deducted from the death benefit, thus reducing the amount your beneficiaries receive. Additionally, if the policy lapses with an outstanding loan, there may be tax implications. Below are common scenarios and how they may affect your loan and taxes:

Policy surrender

• When you surrender your policy, you receive its cash surrender value (cash value minus fees). Any outstanding loan and accrued interest are subtracted from this amount. The difference is taxable as income if the cash surrender value exceeds the premiums paid (adjusted cost base or ACB). 
• If the loan balance exceeds the ACB, it may also be taxable. You forfeit the death benefit by surrendering the policy, leaving no payout for beneficiaries. A surrender could leave you exposed without coverage for future needs and may result in unexpected tax bills, reducing the total cash you receive.

Policy lapse

• A policy lapses when the loan balance plus accrued interest exceeds the policy’s cash value, leaving the insurer with no collateral. A lapsed policy is deemed a disposition, meaning the outstanding loan is compared against the ACB. Any amount exceeding the ACB is taxable as income. A lapse cancels the policy, eliminating the death benefit. You lose all benefits from the policy, including coverage and accumulated cash value, and may face tax liabilities even after the policy ends.

Policy cancellation

• Canceling the policy ends coverage and pays the surrender value minus any loan balance and interest. Like surrendering, the excess is taxable if the surrender value exceeds the ACB. Any unpaid loans may also trigger tax liability. The death benefit is forfeited entirely upon cancellation. Canceling the policy leaves you without insurance protection and could result in financial losses if taxes or loan deductions significantly reduce your payout.

Keeping the policy with outstanding loans

• If the loan isn’t repaid, it accrues interest over time, and the total loan balance is deducted from the death benefit upon your passing. There are no immediate tax consequences as long as the policy remains in force. However, if the loan grows large enough to cause the policy to lapse, tax consequences from the lapse apply. The unpaid loan and accrued interest reduce the death benefit, lowering what beneficiaries receive. The growing balance could cause a policy lapse without monitoring the loan, leaving you without coverage and your beneficiaries with less or no financial support.

Death of the policyholder

• The insurer deducts any outstanding loan and accrued interest from the death benefit before paying the remainder to beneficiaries. Death benefits are typically tax-free for beneficiaries, but the outstanding loan reduces the payout. Beneficiaries receive a smaller payout, depending on the size of the loan. Excessive borrowing could leave beneficiaries with significantly reduced financial support or no payout if the loan balance is very high.

Partial withdrawals or policy changes

• Partial withdrawals reduce the policy’s cash value and may affect the amount available for loans or future growth. Reducing coverage may also lower the cash value and death benefit. Withdrawals exceeding the ACB can trigger taxable income. Policy changes may have tax implications depending on their structure, withdrawals and reduced coverage lower the death benefit available to beneficiaries. Changes to the policy can erode its value, reducing its utility as a financial tool and potentially leaving less for beneficiaries.

By carefully managing your policy and its associated loans, you can avoid unexpected tax liabilities and maintain the intended benefits of your life insurance coverage.

Eligibility and Requirements

• You need a permanent life insurance policy with a cash value to be eligible for a life insurance loan. This portion of the premiums you’ve paid accumulates over time as savings or investments. 
• The policy must be in force and have a sufficient cash value to support the loan. Policies generally take several years of premium payments to build up a sufficient cash value for borrowing.
• Some life insurance companies may have additional requirements or restrictions.

Advantages of Borrowing

Here are some key benefits:

• Lower interest rates: The interest rates are often lower than those on personal loans or credit cards, making borrowing this a more affordable borrowing option.
• No credit check or approval process: When you borrow against your life insurance policy, there’s generally no credit check, income verification, or approval process. This makes it a convenient option for those with difficulty qualifying for traditional loans.
• Flexible repayment terms: It is okay if you don’t repay the loan within a specific time frame. You can make payments as your financial situation allows. However, the loan balance (including interest) will accumulate if you don’t repay it.
• Loan amount based on cash value: The loan amount is typically based on the cash value of your life insurance policy. For most permanent life insurance policies, cash value takes time to grow, providing a potential source of funds as it builds up.
• Continued coverage: Borrowing against your policy does not affect your life insurance coverage. Your beneficiaries will still receive the full death benefit minus any outstanding loan balance and interest at the time of your passing.
• Potential for tax advantages: In Canada, the loan is not taxable income as long as it is repaid. If the loan is not repaid, it may be deducted from the death benefit, but the interest and the loan amount would not be taxed as income.
• No impact on your credit score: Since the policy’s cash value secures the loan, your credit score is not impacted by the loan, even if you fail to repay it. This option can be attractive if you’re worried about affecting your credit score with traditional borrowing.
• Asset protection: The cash value in a life insurance policy is often protected from creditors in certain circumstances, which means borrowing against your policy can be a way to access funds without the risk of losing the asset in the event of financial trouble or bankruptcy.
• No penalties for early repayment: While there are typically interest charges, there are no penalties for repaying the loan early. If you repay the loan faster, you can reduce your interest costs.
• Tax-deferred growth: The cash value of the life insurance policy grows on a tax-deferred basis. While this doesn’t directly impact your ability to borrow, it can make the policy more attractive for long-term savings.
• Accrued interest: If you don’t repay the loan, interest will compound, which could reduce your policy’s death benefit or cash value.
• Reduced death benefit: Unpaid loans, plus accrued interest, are deducted from your death benefit, meaning your beneficiaries may receive less.
• Policy lapse: If the loan balance becomes too high relative to the cash value, the policy could lapse, potentially leaving you without insurance coverage.

Disadvantages

While borrowing against your life insurance policy can offer several advantages, there are some significant disadvantages.

• Reduced death benefit: If you don’t repay the loan, the outstanding amount (including any interest) will be deducted from your policy’s death benefit. This means your beneficiaries could receive less money when you pass away, which might defeat the purpose of having the life insurance policy in the first place.
• Interest accumulation: Even though borrowing from your life insurance typically has a lower interest rate than other loans, the interest still accrues over time. Suppose you don’t repay the loan; the interest compounds, potentially increasing the loan balance significantly. This can erode your policy’s cash value and future growth potential.
• Risk of policy lapse: The policy could lapse if the loan balance (principal + interest) gets too large relative to the policy’s cash value. If this happens, you’ll lose the life insurance coverage and the accumulated cash value, and you may owe taxes on any gains.
• Decreased cash value: If the loan balance grows (if left unpaid), it can reduce the cash value available in the policy. Cash value is often a key benefit of permanent life insurance, and taking a loan against it can diminish its growth and potential future use.
• Tax consequences if unpaid: If the loan is not repaid and the policy lapses or is surrendered, the outstanding loan amount, including any accrued interest, may be considered taxable income. This could trigger an unexpected tax bill, which could be pretty substantial, depending on the loan size.
• Potential for financial strain: If you borrow a large amount against your life insurance policy and cannot repay the loan, you may have a difficult financial situation. While there are no fixed repayment terms, the increasing loan balance can become a burden over time.
• Impact on policy’s growth: The loan reduces the total cash value in the policy, which means it may have less potential to grow over time. Since the cash value is often invested, borrowing against it can interfere with the policy’s ability to earn returns and compound over time.
• Not ideal for short-term needs: Life insurance loans are typically better suited for long-term rather than short-term borrowing. Since the repayment terms are flexible, this type of loan may not be the best option if you need money quickly or plan to repay it soon.
• Potentially complicated terms: Some policies have complex loan terms, including specific interest rates, repayment schedules, or conditions that can affect the overall costs. Understanding the terms before borrowing is essential, or you could face unexpected charges.
• Impact on other financial goals: Borrowing against your life insurance could limit your ability to use the policy for other purposes (such as a source of retirement income or a legacy for your beneficiaries). Taking out a loan may tie up funds that could be better used elsewhere.
• Could affect policy dividends (if applicable): For policies that pay dividends, borrowing against the cash value can impact the dividends you receive. Sometimes, your dividends may be reduced or even eliminated if your loan balance becomes significant.
• Missed opportunity for alternative investment: Instead of borrowing against your life insurance, you might have other investment opportunities that offer a better return or a lower cost of borrowing. Using your cash value for different purposes could be a missed opportunity for better financial growth elsewhere.

Types of life insurance policies

Whole life insurance

Whole life insurance is a permanent policy that covers the insured’s entire life as long as premiums are paid. One of its key benefits is accumulating cash value over time, which grows at a guaranteed rate. Policyholders can borrow against this cash value, typically at lower interest rates than traditional loans. Since the loan is taken against the policy, no credit checks are required, and repayment terms are flexible. 

However, if the loan is not repaid, the outstanding balance is deducted from the death benefit, potentially reducing the payout to beneficiaries.

Universal life insurance

Universal life insurance offers more flexibility than whole life insurance, allowing policyholders to adjust their premiums and death benefits as their financial needs change. This type of policy also builds cash value, which can be borrowed against when needed. The interest rate on these loans varies, depending on the insurer and market conditions. 

If the loan remains unpaid, the outstanding balance and any accrued interest will be deducted from the death benefit. However, policyholders must ensure that their policy retains enough cash value to cover insurance costs; otherwise, it could lapse.

Variable life insurance

Variable life insurance combines life coverage with investment opportunities. The policyholder’s cash value is invested in various sub-accounts, similar to mutual funds, allowing for potential growth based on market performance. Because of this investment component, the cash value can fluctuate, meaning the amount available for borrowing may vary. 

While borrowing against this policy is possible, it carries additional risks since a declining market could reduce the cash value and affect the policy’s sustainability. If not managed carefully, excessive borrowing could lead to policy lapse, leaving the insured without coverage.

Indexed universal life insurance (IUL)

Indexed universal life insurance links the policy’s cash value growth to a stock market index, such as the S&P 500, rather than offering fixed interest rates. This allows for potentially higher returns while still protecting against market downturns. 

Policyholders can take loans against the accumulated cash value, just like with whole and universal life insurance. However, since the cash value is tied to market performance, borrowing too much or experiencing poor market returns could impact the policy’s sustainability. The death benefit will be reduced accordingly if a loan is not repaid.

Alternatives to borrowing

Borrowing against a life insurance policy may seem convenient, but it’s not always the best option. Taking out a policy loan reduces the cash value and can significantly decrease the death benefit if not repaid, leaving beneficiaries with less financial support. Additionally, interest accrues on the loan, and if payments aren’t managed properly, the policy could lapse, resulting in the loss of coverage altogether.

Instead of borrowing, there are better alternatives to consider. A personal loan from a Canadian bank or credit union often provides structured repayment terms without affecting life insurance benefits. For homeowners, a home equity line of credit (HELOC) can offer a lower-interest way to access funds without putting an insurance policy at risk. If retirement savings are available, programs like the Home Buyers’ Plan (HBP), which allows first-time homebuyers to withdraw up to $35,000 from an RRSP for a down payment, or the Lifelong Learning Plan (LLP), which permits RRSP withdrawals for eligible education expenses, may provide access to funds while allowing for repayment over time.

Other options include selling non-essential assets or even considering a reverse mortgage for those 55 and older who own their homes. While some may look into life settlements, where a policy is sold for a lump sum, this option is less common in Canada and comes with regulatory considerations.

Borrowing against your life insurance policy in Canada – Conclusion

Borrowing against a life insurance policy can provide quick access to cash without credit checks or strict repayment terms. Still, it has significant drawbacks, making it a less-than-ideal solution for most people. While it may seem convenient, policy loans accrue interest, reduce the cash value, and can significantly decrease the death benefit if not repaid, potentially leaving loved ones with less financial security. In some cases, excessive borrowing can even cause the policy to lapse, resulting in a total loss of coverage.

The long-term risks often outweigh the short-term benefits, and policyholders should explore all other options before considering a policy loan.

Frequently asked questions about life insurance policy loan Canada

Sources:

1. FCAC, “Life insurance”
2. Advisor.ca, “Accessing insurance policy value through a policy loan”