Understanding Collateral Assignment In Life Insurance Policies

A collateral assignment of life insurance is a method of providing a lender with collateral when applying for a loan. In this case, the collateral is the face value of your life insurance policy, which could be used to pay back the amount you owe in the event of your death before the loan is repaid. The collateral assignment of life insurance is a common requirement for business loans, and lenders may require you to obtain a life insurance policy to be used for this purpose.

Collateral assignment vs absolute assignment

A collateral assignment of life insurance is a conditional agreement where the policy acts as collateral for a loan. The lender becomes the temporary beneficiary of the policy's death benefit until the loan is repaid. The death benefit is used as collateral for a loan, and the lender has a claim to some or all of it until the loan is repaid. This type of assignment is often used to secure small business loans or SBA loans.

In contrast, an absolute assignment involves signing over the entire policy to another person or entity. The original owner gives up all rights and control over the policy, including the right to name beneficiaries and access cash value. The new owner becomes the permanent beneficiary and can manage the policy as they see fit.

Collateral Assignment:

• The policy owner maintains ownership and control over the policy, except for the rights assigned as collateral.
• The lender (assignee) only has rights to the death benefit in the event of the policyholder's death or, in some cases, default.
• The assignment is temporary and removed when the loan is repaid.
• The lender is entitled to the balance of the outstanding loan only.
• The policy must remain current for the life of the loan, with the policy owner continuing to pay all premiums.

Absolute Assignment:

• The policy is fully transferred to a new owner, and the original owner gives up all rights and control.
• The new owner can manage the policy, including selling it, borrowing against it, or changing its terms.
• The assignment is permanent, and the original owner cannot reclaim rights to the policy without the new owner's consent.
• The assignee becomes the permanent beneficiary and is entitled to the full death benefit.

Both types of assignments involve the transfer of rights under the policy and require the consent of the insurance company. It's important to carefully consider the pros and cons of each option before making a decision, as they can have significant financial implications.

How does collateral assignment work?

A collateral assignment of life insurance is a method of providing collateral to a lender when you apply for a loan. In this case, the collateral is your life insurance policy's face value, which could be used to pay back the amount you owe in case you die while in debt.

Here's a step-by-step guide on how collateral assignment works:

• Understand the requirements: Before applying for a collateral assignment, it is important to know the lender's requirements. Lenders generally require an active life insurance policy with a cash value. This means that a term life insurance policy may not be eligible. However, specific requirements may vary across lenders.
• Apply for life insurance: If you don't already have a life insurance policy that meets the lender's requirements, you will need to apply for one. Once approved, confirm with your lender that the policy satisfies their loan criteria.
• Complete the collateral assignment form: After paying the first premium on your life insurance policy, obtain a collateral assignment form from your insurer. On this form, you will need to provide your lender's contact information and designate them as the collateral assignee until your loan is repaid. Both you (the assignor) and the lender (the assignee) will need to sign this form.
• Proceed with the loan application: Once your lender confirms that they are the collateral assignee for your life insurance policy, you can proceed with the loan application process.
• Maintain your life insurance policy: It is crucial to keep your life insurance policy active and in good standing throughout the loan period. Make timely insurance payments to avoid violating your loan contract. Failing to do so may give your lender the right to increase the loan's interest rate or demand full repayment of the outstanding balance.
• Repay the loan: Once you have fully repaid your loan, the collateral assignment condition is removed from your life insurance policy. Your lender will send a written release to your insurer, terminating their status as the collateral assignee.
• Update beneficiaries: With a collateral assignment, you can still name your beneficiaries as usual. However, the total death benefit available to them will depend on when you repay your loan. If you repay the loan before your death, your beneficiaries will receive the full death benefit. If you pass away before repaying the loan, the death benefit will first be used to settle the outstanding loan amount, and the remaining benefit will be distributed to your beneficiaries.

By following these steps, you can use a collateral assignment to secure a loan while maintaining control over your life insurance policy and ensuring that your beneficiaries receive the intended benefits.

Pros and cons of collateral assignment

Pros of Collateral Assignment:

• It enables you to secure business loans or other needed funds.
• It's less risky for a family than using a home or other essential property as collateral.
• You can choose beneficiaries to receive any remaining death benefit funds.
• It may be an affordable option, especially if your life insurance premiums are less than your payments would be for an unsecured loan with a higher interest rate.
• You will not need to place personal property, such as your home, as collateral.
• You may find lenders who are eager to work with you since life insurance is generally considered a good choice for collateral.

Cons of Collateral Assignment:

• The lender has first right to the death benefit, so your family may not get the benefit you intended.
• Lapsing or cancelling the policy could violate your business loan terms, causing problems with the lender.
• You’re responsible for making payments until you die or the loan is paid off.
• The amount that your beneficiaries would have received will be reduced if you pass away before the loan is paid off since the lender has first rights to death benefits.
• You may not be able to successfully purchase life insurance if you are older or in poor health.

Alternatives to collateral assignment

Using a collateral assignment to secure a business loan can help you access the funds needed to start or grow your business. However, defaulting on the loan could mean losing your life insurance policy and your beneficiaries may not receive the money you had planned for them.

• Life insurance loan (policy loan): If you have a permanent life insurance policy with a cash value, you can borrow against it. Policy loans are not taxed and have less stringent requirements such as no credit or income checks. However, this option will not work if you do not already have a permanent life insurance policy as the cash value component takes time to build.
• Surrender your policy: You can surrender your policy to access any cash value you've built up. However, your beneficiaries would no longer receive a death benefit.
• Other loan types: You can apply for other loans, such as a personal loan, that do not require life insurance as collateral. You could use loans that rely on other types of collateral, such as a home equity loan that uses your home equity.
• Unsecured loan: Depending on your credit rating, an unsecured loan may be more affordable than a secured loan with life insurance as collateral. This is more likely to be the case if you have good enough credit to qualify for a low-interest rate without having to offer any type of collateral.
• Home equity line of credit (HELOC): A HELOC is a flexible way to access funds without the risk of putting up your life insurance policy as collateral. While your home is used as collateral, you retain more control over the amount you borrow and only pay interest on the actual amount borrowed.

When to consider a collateral assignment

A collateral assignment of life insurance is a useful option if you want to access funds without placing any of your assets, such as a car or house, at risk. It is also a credible choice if you have a low credit rating, which can make it difficult to find attractive loan terms. Here are some scenarios in which a collateral assignment may be beneficial:

• You already have a life insurance policy: If you already have a life insurance policy in place, assigning it as collateral can be a simple process. You may even be able to use your policy as collateral for more than one loan, which is called cross-collateralization, as long as there is enough value in the policy.
• You have a low credit score: A collateral assignment may be a good option if your credit rating is not high. Since the lender can rely on your policy's death benefit to repay the loan if needed, they may be more inclined to offer you favourable loan terms despite your low credit score.
• You want to avoid using personal property as collateral: Using life insurance as collateral means you don't have to put up your house, car, or other personal assets as security for the loan. This can be especially beneficial if you want to avoid risking these assets in case you default on the loan.
• You are seeking a secured loan with lower interest rates: Secured loans tend to have lower interest rates than unsecured loans, so using life insurance as collateral can help you borrow money at a lower cost.
• You need funding for a business or major expenses: A collateral assignment can be a good way to secure funding for starting or growing a business, or for covering major expenses such as hospital bills.

Frequently asked questions