What is Collateral Assignment Life Insurance?

A life insurance collateral assignment is when you use your policy’s cash surrender value as collateral to get a loan. Until you pay off the debt, the lender has a claim to some or all of the death benefit.

Appointing the lender as an assignee (rather than a beneficiary) limits their death benefit claim. If you pass away, they can receive the remaining loan balance. After the loan has been repaid, the remaining benefit will be given entirely to your beneficiaries.

Collateral assignment of life insurance is usually a prerequisite for business loans. It ensures the lender will not lose its money even if the business owner dies before repaying the loan.

Individuals who need a loan, like a personal or home loan, can also use collateral assignment. Let us say you have a $100,000 policy and take out a loan of $70,000 by collaterally assigning your policy. Your spouse is the only beneficiary of the policy, while the lender is now named the assignee.

Now, let’s say you pass away before repaying the loan. In this situation, the insurer will first pay the lender $70,000, while the remaining $30,000 will go to your spouse.

Key Takeaways

• The borrower should be the policy owner of the policy offered as collateral.
• Collateral assignment requires you to assign the lender as a beneficiary.
• All or part of the life insurance's death benefit can be used as loan collateral.
• If the insured dies before the loan is repaid, the lender has the first dibs on the death benefit.
• Upon the repayment of the loan, the lender ceases to be the assignee of your policy, meaning the entire benefit will now be distributed among your beneficiaries should you die. 
• The collateral assignment of life insurance is common in the case of business loans, but individuals may also use life insurance as collateral for personal loans, like a mortgage.

Understanding Life Insurance Loans

What is a life insurance loan?

A life insurance loan is a unique financial tool that allows policyholders to borrow money against the cash value of their life insurance policy. Offered by life insurance companies, these loans use the life insurance policy's cash value as collateral, making them a secured form of borrowing. The loan amount is typically a percentage of the policy’s cash value, and the interest rates are generally lower than traditional loans. This makes loans an attractive option for those looking to access funds without the high costs associated with other loans.

Life insurance as loan collateral

Not all life insurance policies are eligible for use as collateral. Permanent life insurance policies, such as whole and universal life insurance, are the most suitable because universal life insurance can accumulate a cash value over time. This cash value can be used as collateral for a loan. On the other hand, term life insurance policies do not build cash value and, therefore, cannot be used as collateral. When considering a loan, it’s essential to understand your policy type and whether it qualifies for this borrowing option. Additionally, universal life insurance can also be a valuable tool for estate planning and wealth transfer. It provides a death benefit that can help cover estate taxes or other expenses, ensuring that beneficiaries receive a larger portion of the estate.

How does borrowing against a life insurance policy work?

Borrowing against a life insurance policy involves leveraging your policy's cash value as collateral for a loan. Essentially, the policyholder can access a portion of the cash value, typically up to 90%, for various financial needs such as paying off debt, funding a business venture, or making a significant purchase. One of the key advantages of this type of loan is that it is generally tax-free, meaning you won’t have to pay taxes on the borrowed amount. Additionally, borrowing against your life insurance policy does not impact the death benefit, ensuring that your beneficiaries will still receive a payout, albeit reduced by the loan amount if it remains unpaid.

The interest rate on these loans can vary depending on the life insurance company and the specific terms of your policy. It’s important to review these terms carefully to understand the cost of borrowing and how it might affect your policy’s cash value over time. By using the cash value as collateral, you can secure a loan without undergoing a credit check, making it an attractive option for those who need quick access to funds without affecting their credit score.

How collateral assignment of a life insurance policy works

Pledging your life insurance policy to secure a loan assures the lender that it will not lose money even if you die before repaying the loan. In the event of your untimely death, the lender can recoup the loaned amount from your policy’s proceeds.

When it comes to collaterally assigning a policy, there are a few things you must keep in mind:

• The borrower must be the policy owner.
• The policy must remain in force for the entire duration of the loan.
• The death benefit must be more than the borrowed amount.
• While term and permanent life insurance policy can be collateral, many lenders only accept the latter.

Term life insurance policies provide coverage for a limited period and do not accumulate cash value. In contrast, a permanent life insurance policy covers your entire life and gathers cash value. Your life insurance policy's cash value, like a house or vehicle, is a tangible asset that may be used to secure a loan.

When you offer a permanent life insurance policy as collateral, the lender can recover its money in both these scenarios:

• You die before repaying the loan
• You default on the loan

If you die without repaying the lender, they can recover the borrowed amount from the policy’s death benefit. And if you fail to keep up with the loan payments, they can seize the policy’s cash value. Remember that your access to the cash value will be restricted during the duration of the loan. Once you repay the loan, the lender will be removed as an assignee, and you will once again enjoy complete control over the cash value.

Since a term life insurance policy does not include a cash-value component, it is useless to the lender in the event of default. For this reason, many lenders require a permanent policy over a term plan for the collateral assignment.

Here is a real-life example that clearly explains how the collateral assignment of a life insurance policy works and the best way to understand it:

Joe wants to set up a web-designing business and needs a loan of $55,000 to get started. He owns a permanent life insurance plan with a death benefit of $100,000 and a cash value of $62,000. Joe approaches the bank for a loan and offers his policy as collateral, which the lender accepts. Since the borrowed amount is less than the policy’s cash value, the lender knows it will get back its money if Joe defaults.

And if he passes away before the loan is repaid in full, the lender would get first digs at the death benefit. Also, because both the death benefit and cash value exceed the loan amount, Joe’s beneficiaries would still receive a cash payment after his death, even if he passes without repaying a cent.

How to apply

The process of setting up a collateral assignment may vary from one insurer to another, but it usually involves the following steps: 

1. As a policy owner, you must get written consent from the lender.
2. Contact your life insurance company and request a collateral assignment form.
3. Fill out the form, providing the loan amount, lender's contact information, and policy number.
4. The insurer will review your request. If approved, it will issue a collateral assignment certificate to the lender. This certificate confirms the latter's claim to the life insurance proceeds.

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Is a collateral assignment right for you?

Collateral assignment of life insurance means taking out a loan by pledging your policy. When you do so, the lender becomes an assignee of your policy. Should you pass without repaying the lender, it would recover the borrowed amount from the death benefit.

While it is possible to use any type of policy for collateral assignment, lenders usually prefer a whole life insurance policy. These plans accumulate financial value and, as a result, can assist the lender in recouping its money if you default but do not die.

If you have more questions, contact a Dundas Life licensed insurance advisor today.

Frequently Asked Questions (FAQs)

Who can use the collateral assignment of a life insurance policy?

In Canada, business owners commonly use collateral assignments to qualify for a business loan. However, individuals can also benefit from offering a life insurance policy as collateral for a loan. Since traditional secured loans have lower interest rates than unsecured debts, this decision might save you significant money in the long run.

Are there any restrictions on the collateral assignment of a life insurance policy?

Depending on the location and insurer, collateral assignments may be subject to certain restrictions. Common restrictions are as follows: 

• Not all policies allow collateral assignments (So read the policy terms before applying for a loan).
• The insurer may allow collateral assignments only on policies with a death benefit greater than a certain amount.
• The insurer may require the policy owner to maintain a certain amount of life insurance coverage after assignment so the policy beneficiaries could still receive a payout.

Are there alternatives to the collateral assignment of life insurance policy loans?

However, you run the risk of losing coverage if you are unable to make loan payments. If you default on the loan, your policy beneficiaries will not receive the financial assistance you wanted them to receive upon your death. Given this risk, it may be worthwhile to consider other options, such as: 

• Life insurance loan: Do you have permanent life insurance with a high cash value? If so, the insurer may be willing to extend you a loan. A policy loan is not subject to tax while the policy is in force. Also, funds borrowed do not have to be repaid, as you are essentially borrowing your own money. However, if you die before repaying the loan, the outstanding loan balance would be deducted from the death benefit. This means your beneficiaries would receive a smaller payout than you intended. 
• Surrendering the policy: Another option is to cancel your permanent life policy. Since these policies accumulate cash, you will receive a payout upon canceling coverage. The payout depends on the policy's cash value, surrender charges, and other loans. Remember that once you surrender the policy, the coverage will end, meaning your beneficiaries will not receive any payment when you pass. 
• Other loan types: Finally, you may consider other types of loans, such as a home equity or personal loan.