How Policy Loans Work in Life Insurance (Canada)

How Policy Loans Work in Life Insurance

Policy loans are often mentioned as a feature of permanent life insurance, but they’re also one of the most misunderstood parts of how these policies work.

This guide explains what a policy loan actually is, how it works in Canada, and the important trade-offs to understand before considering one.

No pressure — just clear information to help you make sense of it.

What Is a Policy Loan?

A policy loan is a loan taken against the cash value inside a permanent life insurance policy, such as Whole Life or Universal Life.

Instead of borrowing from a bank, you’re borrowing from the insurance company, using your policy’s accumulated cash value as collateral.

Key points:

• Policy loans are only available on permanent policies
• Term life insurance does not have policy loans
• The policy remains in force as long as it stays properly funded

How Policy Loans Actually Work

When you take a policy loan:

• The insurer lends you money
• Your policy’s cash value secures the loan
• Interest begins accruing immediately

You don’t have to qualify based on income or credit, but the loan is not “free money.” It’s still a real loan with real consequences if unmanaged.

Important detail:
The loan does not remove cash value from your policy — it’s a lien against it.

Where the Loan Money Comes From

Contrary to popular belief, you are not borrowing your own cash directly.

Instead:

• The insurer lends funds from its general pool
• Your policy’s cash value is used as security
• If unpaid, the loan plus interest reduces the death benefit

This distinction matters, especially when understanding interest and long-term effects.

Interest on Policy Loans

Policy loan interest rates vary by insurer and policy type, but they:

• Are set by the insurance company
• Can be fixed or variable
• Accrue annually

Interest is typically not tax-deductible, since the loan is considered a personal loan.

If interest isn’t paid, it compounds and is added to the loan balance.

Do Policy Loans Need to Be Repaid?

Technically, repayment is optional — but practically, it matters a lot.

You can:

• Repay the loan at any time
• Pay interest only
• Let the loan remain outstanding

However:

• Unpaid loans reduce the death benefit
• Large loans can cause a policy to lapse
• A lapse with an outstanding loan can trigger tax consequences

This is where careful monitoring becomes essential.

Tax Implications of Policy Loans in Canada

Policy loans themselves are not taxable when taken.

However, taxes may apply if:

• The policy lapses or is surrendered
• The loan balance exceeds the policy’s adjusted cost base (ACB)

In those cases, the outstanding loan can create a taxable gain, even if no cash changes hands.

This is one of the most overlooked risks.

Policy Loans vs. Withdrawals: What’s the Difference?

While both access cash value, they work differently:

Policy Loan

• Borrowed funds
• Interest applies
• Death benefit reduced if unpaid
• No immediate tax when taken

Withdrawal

• Permanent removal of cash value
• May trigger tax
• Reduces future growth
• Often limited by policy structure

Each has trade-offs depending on the situation.

When Policy Loans Can Make Sense

Policy loans may be appropriate when:

• Short-term liquidity is needed
• Cash flow timing matters
• The policy is well-funded and monitored
• The borrower understands the long-term impact

They work best as a planning tool, not a default strategy.

When Policy Loans Can Create Problems

Policy loans can become risky when:

• Used repeatedly without repayment
• Taken early before sufficient cash value exists
• Interest is ignored
• The policy is minimally funded

Many issues arise not from the loan itself, but from lack of ongoing oversight.

Why Policy Loans Require Ongoing Guidance

Policy loans are not a “set it and forget it” feature.

They require:

• Annual reviews
• Monitoring loan-to-value ratios
• Understanding how interest affects the policy
• Awareness of tax thresholds

This is why thoughtful guidance matters more than speed or simplicity.

Final Thoughts

Policy loans can be useful in the right context, but they are not magic, guaranteed, or risk-free.

Like most aspects of permanent life insurance, they reward:

• Patience
• Understanding
• Long-term thinking

Slowing down and learning how they truly work often leads to better outcomes — and fewer surprises.

If you’d like to explore whether a policy loan makes sense for your situation, it’s worth having a calm, informed conversation — with no pressure attached.