Am I borrowing my own money?

How it works

Read the paperwork and the roles are named. One party pays money out and records a claim. The other party receives it and owes it back with a charge for the use of it. Nothing in that arrangement changes because the collateral happens to sit inside a contract you own. That arrangement also stays outside the credit system entirely, a point covered in do policy loans affect my credit.

The cost or the catch

the cheapest coverage, for a while

What term life insurance does and does not do

1. 01Coverage for a fixed period, usually ten to thirty years
2. 02It pays if the insured dies within the term
3. 03It pays nothing if the insured does not
4. 04It has no cash value at any point
5. 05It costs a fraction of permanent coverage

The phrase costs people money because it removes the sense of an obligation. Someone who believes the money was already theirs sees no reason to pay it back, and the figure quietly grows for twenty years Here is what actually happens. until an insurer's letter arrives and there is very little left to do about it. Should the insured die with that balance still outstanding, what happens when the insured dies explains how the amount owing is settled from the death benefit.

What to verify yourself

name the alternative, or there is none

The comparison that is actually honest

1. 01The usual case compares an advance to an outside loan
2. 02That holds only if you would have borrowed anyway
3. 03If you would not have, compare it against paying cash
4. 04Interest on an advance is paid to the insurer
5. 05A comparison is incomplete until the alternative is named

Asking the insurer for a written definition of the operation, in the contract's own words, before presenting it to a third party as a withdrawal or as a loan, keeps a household from adopting language the document itself does not share.

The mechanism, step by step

The request is made to the insurer, not to the policy itself, and it is the insurer's general fund that pays the money out, not the accumulated value inside the contract, which is why the accumulated value is described as collateral and not as a source of funds. Once the request is approved, the insurer records a debit against the contract and begins charging interest on that debit from the day the money leaves, at a rate the contract either fixes at issue or resets on a schedule the contract states. No repayment schedule is imposed the way a conventional lender imposes one; a policyowner may pay interest only, may pay nothing at all, or may repay principal on any timetable chosen, and the insurer's only recourse for a debit left unpaid is to let the interest compound and, eventually, to reduce what remains payable at a claim.

That last point is the one most often missed. The insurer is not indifferent to whether the debt is repaid; it simply collects on its own schedule and not a monthly one, taking its due either from a future request the policyowner makes, from a surrender the policyowner initiates, or from the death benefit itself when the insured dies. The debt does not disappear because nobody asked for it back in the meantime, and the person who signed the request is the only party who can decide, at any point along the way, to send money back in and stop the interest from compounding further.

What varies by insurer and by contract

frequently the same person, not always

Three roles inside one contract

1. One contractAll three can be different people, and only the policyholder can change the contract.
2. The policyholderOwns the contract and holds every right.
3. The insuredThe person whose life is covered.
4. The beneficiaryReceives the death benefit.

Two features decide how a debit against the contract actually behaves over time, and both differ by insurer and sometimes by product line within the same insurer. The first is the interest rate charged on the amount owing, which some contracts fix at issue and others reset annually according to a formula or a declared rate, so the same debit can cost noticeably different amounts from one insurer to the next even where the principal borrowed is identical. The second is whether the insurer continues crediting the full accumulated value with participations as though nothing had been borrowed, an approach usually called direct recognition, or instead credits participations only on the portion that remains unborrowed, an approach usually called non direct recognition. A household reading two illustrations side by side, one from each kind of insurer, will see the borrowed amount treated very differently in the year following a debit, and the illustration itself rarely explains which approach it assumes unless asked.

The question of whether that continued crediting on the pledged amount actually happens, and on what terms, is answered contract by contract and not by a general rule, which is why does cash value keep growing with a loan is worth reading as a companion to this page and not assumed from what a neighbour's contract happens to do.

What to ask, and of whom

each one taxed differently

Three ways to reach the value, often confused

1. 01An advance, A withdrawal, A surrender
2. 02The contractStays intact, under its terms; Value is removed permanently; Ends.
3. 03The death benefitReduced while a balance is outstanding; Usually reduced, and not restored later; Ends with the contract.
4. 04Can it be undoneYes, by repaying the balance; No, not by paying money back; No, and insurability may not be there again.
5. 05TaxNot taxed when made, but it is a disposition; Amounts above the adjusted cost basis can be taxable; Amounts above the adjusted cost basis are taxable.

The insurer, not a general description of the product, is the source for three specific answers: whether the interest rate on an outstanding debit is fixed for the life of the contract or reset periodically and by what formula, whether the insurer uses direct or non direct recognition on the pledged portion, and what the current combined balance of principal and accrued interest is as of today's date, in writing rather than from memory. A household asking these questions before a debit is requested, rather than after, is in a position to compare what one insurer's contract will actually cost against another's, since the coverage amount on the proposal page tells a reader nothing about either of these two mechanics. A fourth question worth adding to the same letter is whether any minimum amount applies to a single request, and whether more than one outstanding debit can exist against the same contract at once, since some insurers consolidate every request into one running balance while others track each request separately with its own interest clock.

Who this confusion costs the most

The phrase in the page's own title tends to mislead a specific kind of household hardest: one that has heard the arrangement described informally, in language that suggests the money was always theirs to move around freely, and that treats a debit against the contract the way it would treat a transfer between two of its own accounts. That household is the one most likely to let a balance run for years without tracking it, because nothing about the transaction feels like an obligation to anyone involved, right up until the accrued interest becomes large enough to affect what a death benefit or a surrender actually pays out. A household that already tracks debts of every kind, on a personal balance sheet updated at least once a year, is largely immune to this particular mistake regardless of how the arrangement gets described to it socially, because the balance sheet does not care what a debit is called.

What this page will not tell you

This page explains why the transaction is a loan and not a withdrawal, and where the terms that decide its cost are found. It does not tell a household whether taking a specific amount, for a specific purpose, at a specific point in life, is a sound use of the arrangement, since that judgment depends on the household's own cash flow, its other debts, and its own tolerance for a balance that grows quietly if left unattended. It also does not describe what happens to that balance for tax purposes, a separate question answered in are policy loans taxable in Canada and finally owned by the household's own accountant. The decision to request an amount, and how it fits the rest of a household's finances, belongs with the household and with the licensed Financial Security Advisor reviewing the file, not with a page written to explain the mechanics in general terms. Now you decide.