Assessing cash value in permanent life insurance is one of the most significant concerns for policyholders. In this article, let’s find out two typical ways for you to do this.
Cash value – a feature of permanent life insurance
You will always be offered a death benefit when you buy term life insurance or permanent life insurance. The death benefit is the money your beneficiaries will receive upon your death as long as your policy is in effect. Cash value is a unique feature of lifelong life insurance policies not included in term life insurance.
Cash value is a part of the monthly premium that you pay to your insurer. As you are alive, you can have access to this money and use it at your disposal. The cash value is one of the advantages of permanent life insurance in comparison to term life insurance. Among different ways to assess cash value, policy loans and leverage are the most common ones.
Policy loans – borrowing from your cash value
What is a policy loan?
If you own a permanent life insurance policy, may it be whole life insurance or universal life insurance, you have the choice to borrow from it. By doing this, you are taking out a loan from your insurer, with the cash value being the collateral. This means that even when you are getting a loan, your cash value remains intact and carries on making interest.
Usually, you can expect to borrow up to 90% of the value of your cash value, and there is no minimum for this. The loan is generally tax-deduced. Plus, you will have to pay a fixed amount of interest rate.
How to take out a policy loan?
The process is relatively straightforward. Once you’ve decided that you need a policy loan, you just need to contact your insurer to inform them of your decision. They will send you a form to fill out. Once you’ve done this and sent back the form to the insurer, they will send the money to you within 48 hours. You are expected to verify your identity or sign a confirmation document in the following cases:
- The loan is over a set of amount, for example, $100,000
- You have just changed your account information within a month
- The ownership of the policy has changed recently
Advantages of a policy loan
There are several advantages of this way of assessing cash value.
Firstly, there’s no need for you to be qualified for a policy loan. You are not required to show proof of income, either. In addition, there is no credit check, and thus the loan is not included in your credit report. All you need to do is to contact your insurer and tell them your request. In most cases, you’ll be able to receive the money within 48 hours. Life insurance policy loans are more flexible than other loans, allowing policyholders to get cash without a long waiting period.
Secondly, the policy loan is not taxable as income, if what you take out doesn’t exceed the adjusted cost basis (also known as ACB) of your life insurance policy. Basically, the calculation of ACB involves all payments into, withdrawals or loans from, dividends and the net cost of pure insurance charges of your policy. As long as your policy loan is lower than the ACB, it is non-taxable.
Thirdly, the initial interest rates of policy loans are lower than those from banks. Usually, there are two types of interest rates: interest in advance and interest in rears. If you choose the former, you know in advance the amount of interest you must pay for a year and thus can plan to pay back your debt.
Fourth, since you are borrowing from your insurer with the cash value as the collateral, the money you take out can accumulate interest. In other words, you can still gain interest (or dividends) in the amount of loan that you take out. However, the claim is offered at a much lower rate than that of the remaining cash value.
Finally, unlike other types of loans, you are not required to repay your policy loan within the due date. This means that you can be flexible in planning when to pay it back.
Risks of a policy loan
Although policy loans are offered at a low rate, and you have some room to decide when to repay them, problems arise when you delay your repayment. All this has to do with the interest rate.
Again, let’s assure you that the interest rate from a policy loan is much lower than that from your credit card or bank. However, interest compounds, and so does the amount of your debt. Unless you pay your interest in time, there will come the point when your loan value exceeds your cash value, causing your policy to lapse.
To illustrate, let’s say you want to apply for a loan of $30,000, with an interest rate of 5%. This table shows how your loan balance will accumulate through the years.
|Year||Interest amount||Loan Balance|
As you can see on the table, if you delay your table, say for five years, then after five years, your loan balance will go up to almost $38,288.45 compared to the initial balance of $30,000. As you continue to delay the payment, terrible things will happen.
The first scenario is that you end up reducing the amount of death benefit for your beneficiary. When you take out a loan, you borrow the death benefit that your beneficiaries would later receive in advance. If you die before paying out the debt, your carrier will deduce the face amount of the death benefit that your beneficiaries receive.
“The so-called liability of the policyholder never exists as a personal liability, it is never a debt but is merely a deduction in account from the sum the plaintiffs (the insurer) ultimately must pay,” U.S. Supreme Court Justice Oliver Wendell Holmes (1910).
To illustrate, let’s imagine your son is entitled to receive a death benefit of $500,000 upon your death. However, as you die, you still owe $38,000 to your insurance company. Thus, your beneficiary will only receive $462,000 in the end (excluding other fees).
A more dangerous scenario is when your loan value exceeds your cash value. At this point, your policy will be terminated by the insurer. Your policy loan balance will be counted as a taxable income, and you will be required to pay all the bills.
Advices on monitoring policy loans
It’s worth repeating that policy loans are not bad, though they should be dealt with tactfully. Usually, your insurance company doesn’t give you any loan repayment schedule or repayment date. They do not notify you to pay back the loan balance, either. Therefore, self-management here is the key.
We advise you to make a partial or entire repayment of your loan as soon as possible. Also, remember to ask your insurer for an in-force policy illustration every year to keep track of your loan balance.
Leveraging – Using your cash value as the collateral
Apart from policy loans, another option to assess your cash value is to use it as collateral to borrow from a financial institution. This option is open to both businesses and individuals. Like policy loans, you will be required to pay an interest rate from 6-10%.
The maximum amount of loan often depends on your cash surrender value (CVS). Usually, you can expect to take out from 50 to 90 % of the CVS.
To use the leverage option, there are two strategies available:
- Back-end leveraging strategies, also known as Insured Retirement Plans (IRPs): This strategy is used to increase RRSP or RPP income;
- Front-end strategies or Immediate Financing Arrangements (IFA): This strategy is used to deduct the interest cost when clients make investments in real estate or stocks with a foreseeable profit. This is the more popular option for businesses and individuals.
How to apply for leveraging?
Unlike policy loans, which are pretty easy to request, it is hard to arrange leverage. The client (either an individual or a company) is asked to provide proof of personal or corporate income tax returns within three years, supporting IFA illustrations, net worth statements and financial statements. It’s essential to bear in mind that the loan will not be approved.
Benefits of leveraging
This strategy is so appealing because clients can benefit from tax-free loans insofar as the current Canadian tax laws. After all, a tax-free cash flow is so attractive. Young companies or start-ups can use this to scale up their business, make investments and so on. Likewise, many affluent individuals make use of this approach to invest in stocks or real estate.
An additional benefit is that loan interest can be deductible on the condition that clients use the loan proceeds to create income from property or business. The amount deductible is determined by the lower premium paid and the net cost of pure insurance (NCPI).
As the saying goes “High risk, high return,” there are several risks that companies and individuals need to consider before choosing this approach.
Mortality risks: Normally, the financial institutions will have ways to ensure a cap on the maximum loan amount as the insured is alive. However, in some cases, the insured outlived the expected longevity. The loan balance will start to exceed the maximum percentage of the cash value. If this happens, the policy owners will have to add more collateral or pay off part of the loan balance. Failure to do so would lead to the termination of the policy.
Financial risks: When clients fail to make returns from their loan usage to make up for the loan amount, there are high chances that the accumulated loan balance exceeds the CSV. If this happens, clients have no choice but to either add more collateral or repay the loan. Or else the loan owners will force your policy to lapse. In addition, financial institutions may ask for a re-qualification of clients’ existing loans. The re-qualification may go with a new interest rate, additional collateral or repayment request. Should this happen, companies will have to pay additional fees as a result.
Tax risks: If clients’ businesses do not go well, they may no longer enjoy the interest expense deduction. This means that they will be further burdened with the interest rate apart from the loss of profits. Also, tax laws change rapidly, so there is no guarantee that clients will forever enjoy deductible interest.
Advice on monitoring leveraging
Now that we know all the risks you may encounter, we have better preparations for unfavorable scenarios. Before choosing this approach, clients should have detailed, long-term financial planning on using the loan, when to make the necessary repayment, etc. They also need to think of backup plans should their business not go well as well as any additional collateral and/or liquidity to prepare for the worst cases, etc.
To sum up, in this article, we have provided you with further insights into two ways of assessing cash value: via policy loans or leverage. Usually, individuals or businesses can borrow up to 90% of their cash value. The loan can be non-taxable, with specific terms and conditions. It is easier to ask for a policy loan than a leverage, and there are several risks that clients need to consider before making the decision.
We understand that taking out a policy loan or a leverage can be a difficult financial decision. If you have any further questions, want to get life insurance quotes and more, don’t hesitate to leave a comment below, drop a message in the chatbox or via our Contact page.
Frequently Asked Questions
How long does it take for policy owners to take out policy loans?
It is true that you cannot take out a policy loan immediately after your policy purchase. Again, requesting a policy loan means that you are using your cash value as the collateral. Therefore, by the time you make the transaction, the cash value should have grown enough in value to be qualified.
Usually, you will need to wait for 5-15 years to apply for a policy loan. Your waiting time depends on the face value of your policy. This is because the cash value accumulates faster in policies with a high face value.
Is there any way to calculate taxable income from a policy loan?
Yes, sure. You can have an idea of your taxable income by following these steps:
Step 1: Do a sum of your net CSV, loan balance and dividends (if any)
Step 2: Subtract your ACB
For example, your loan balance is $200,000 and your ACB is $170,000, the taxable income would be $30,000.
Note: The above example is just a simplified demonstration according to the general rule. It’s recommended that you consult your tax advisor to confirm whether you have a taxable income or not.
Can policy owners choose the types of interest that they pay for their policy? What is the difference between the two types?
Policy owners can choose the way that they want to pay their interest. There are two types of interest: interest in advance and interest in arrears.
– Interest in advance: You are expected to pay for your loan in advance at a fixed interest rate. This means that you are expected to carry on your loan during that year. Therefore, even if you repay your loan during the year, you will not receive any refund on the paid interest.
– Interest in arrears: You are expected to pay for your interest at the end of your policy year. In this case, your interest accumulates daily. If you pay off your loan during the year, you will not have to pay for the interest of the remaining days.
Can a beneficiary request a policy loan without the policy owner’s permission?
In most cases, no. The policy owner is entitled to make all decisions regarding the changes in their policy. Generally, the beneficiary cannot ask for a policy loan without the policy owner’s permission. There are only two cases where the beneficiary can do this:
– The beneficiary is also the policy owner. For example, a wife purchases life insurance with her husband being the insured and she being the beneficiary. In this case, the wife is both the policy owner and the beneficiary.
– The policy owner entrusts someone to make financial decisions on their behalf. In this case, the trustee can change the life insurance policy.
What is the difference between a collateral assignment and a movable hypothec?
Except for Quebec, all Canadian provinces request a collateral assignment when individuals or businesses want to use their life insurance policy as collateral for a loan (leveraging).
In terms of the collateral assignment, the financial institution does not possess any ownership over the policy. Nonetheless, it has the right to prevent any action under the policy that would harm its security interest. The financial institution can also decide the procedure proceeding up to the loan balance upon the insured’s death if there is any remaining loan.
In Quebec, a movable hypothec is similar to a collateral assignment because the financial institution does not own the policy. However, it reserves the right to make decisions as far as the loan balance is concerned.
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