The difference between life insurance and mortgage life insurance
Why insurance is important
Insurance has existed for as long as humans have lived, traded goods, sold services and owned possessions. It doesn’t save lives or prevent the theft or destruction of property, but it does provide money to compensate for loss. That’s the essence of insurance, whether we’re talking about vets’ bills, missing luggage and stolen phones or liability for car accidents, the cost of private health and the loss of a loved one.
Insurance falls broadly into two categories: general and protection. Protection insurance essentially means life insurance or any insurable risk that’s entirely financial, such as income protection. General insurance covers everything else.
Life insurance and mortgage protection are two forms of protection insurance. In many circumstances they are virtually interchangeable, designed for similar purposes; but while all mortgage protection is life insurance, not all life insurance is mortgage protection.
Understanding life insurance
Here’s a brief overview of life insurance
What is it?
It pays out a lump sum on the death of the insured individual (usually but not always the policyholder). Its purpose is to give financial support to family and dependants whom the insured leaves behind.
What are the different types of life insurance?
There are many variations on this central idea. Perhaps the most notable are those that provide fixed or variable levels of cover:
Level: the payout and premiums remain the same throughout the policy
Decreasing: the payout reduces over the life of the policy (although the premiums don’t)
Increasing: the payout and premiums increase over the life of the policy.
There are also fixed length policies and open-ended ones:
Term life: insurance cover lasts for a pre-agreed time, such as 30 years.
Whole life: insurance cover lasts until the end of the insured’s life.
What is life insurance used for?
Income
The most obvious use is to provide money for people left behind, perhaps because they would struggle without the deceased’s income, or simply to give them a financial boost.
Expenses
The proceeds from a life insurance policy can be used to cover significant future costs, such as school or university tuition fees.
Debts
They can also be used to pay off any outstanding loans that survive the deceased, which brings us into the territory of mortgage life insurance.
Understanding mortgage life insurance
What makes life insurance for mortgages a separate concept?
What is it?
It’s insurance taken out on the life of an individual (normally but not necessarily the policyholder) specifically designed to pay off an outstanding mortgage should the mortgagor (the person who borrows the money) pass away.
How it works
Mortgage protection often takes the form of decreasing term life insurance. With a policy of this kind, the final payout decreases over time. This is because the outstanding balance of a repayment mortgage also decreases until it’s fully paid off. It’s impossible to know when you take out a mortgage loan how much will be repayable, since interest rates fluctuate. For that reason, decreasing mortgage protection policies are regularly reviewed to ensure they’re neither falling short of their purposes nor generating a larger payout than the insured wants.
Decreasing term insurance isn’t the only form of mortgage protection. You can choose level or even increasing if you wish and in both cases there may be money left over to pass on to dependents. As long as you can be sure the policy will produce sufficient funds to pay off the mortgage loan, it should do its job.
One important question when setting up mortgage life insurance is the identity of the named beneficiary. It’s common for the lender (the mortgagee) to be named in the policy. There’s no legal obligation to do this, but some lenders may require it as a condition of granting the loan. This may not be ideal because it can make it hard for the policyholder’s heirs to take control of any funds left over after repayment of the mortgage.
It's also common for the beneficiaries to be relatives or friends of the insured. In these cases the funds won’t go directly to the lender but will have to be transferred to them by the beneficiaries. This doesn’t usually create any difficulties, since the debt will otherwise pass into the estate of the deceased and become the responsibility of the beneficiaries anyway.
How is mortgage life insurance used?
The principle of its operation is always essentially the same although it can lead to slightly different outcomes as a result of other factors, legal and otherwise. Let’s consider a couple of examples.
1. A married couple buys their home jointly with a 30-year repayment mortgage. They are joint tenants, which means if one dies the home becomes the property of the other automatically, without formal inheritance, probate or tax.
The husband takes out decreasing mortgage life insurance to pay off the mortgage if at any point one of them passes away during those 30 years. The wife is the beneficiary.
The husband dies after 20 years. The wife is now the sole owner of the house, but she doesn’t own it outright because 10 years remain on the mortgage. She receives the payout, pays off the balance and becomes sole owner of the unencumbered property.
2. A married couple buys their home jointly with a 25-year repayment mortgage. They are joint tenants.
They take out level term life insurance to cover the mortgage. Their lender is named as beneficiary.
They both die in an accident after 20 years. The life insurance policy pays out to the lender, who uses the proceeds to settle the outstanding loan.
The house passes into the couple’s estate and is inherited - unencumbered but subject to inheritance tax - by their children according to their will.
Mortgage life insurance vs life insurance: the main differences
Purpose
Perhaps the biggest difference between life insurance and mortgage life insurance is the purpose for which they’re taken out. Life insurance is usually intended to give general financial support to family, dependants and friends. Mortgage life insurance is specific to the imperative of paying off the mortgage loan if the borrower dies.
Cover
Life insurance can have level, decreasing or increasing payouts and can last for the lifetime of the insured or for a fixed period. Mortgage life insurance is much more frequently chosen in the form of decreasing term insurance.
Joint or single
Both life insurance and mortgage life insurance can be set up as single or joint policies.
Beneficiaries
The policyholder can choose the beneficiaries of their life insurance policy. The same is true for mortgage protection although it’s common and usually neater to name the lender as beneficiary. Some lenders may make this a condition of the mortgage contract.
Flexibility of payout
The proceeds of a life insurance policy can be put to a broad range of uses, while the payout from mortgage life insurance is narrower in scope. Its purpose is solely to pay off the outstanding loan. Any funds left over can be transferred to other beneficiaries or family and friends, but in most cases there will be little or nothing left.
Cost
Mortgage life insurance is generally a cheaper option – certainly if it is a decreasing term policy – because its diminishing nature means that, although the premiums don’t decrease, they are lower than level or increasing term policies, both at the start and throughout.
The pros and cons
Finally, if you’re unsure whether to take out one or the other – or even both – it’s worth weighing up the advantages and disadvantages of each.
Life insurance
For:
It can provide financial help for circumstances beyond mortgage repayments, such as the future expenses of your family, both known and unknown.
Against:
The premiums are generally higher than mortgage life insurance and if you choose an increasing term policy they will increase.
Mortgage life insurance
For:
It’s less expensive than standard life insurance
With regular reviews it’s guaranteed to pay off your mortgage
Against:
It’s limited to repaying your outstanding mortgage so is unlikely to yield any excess funds.
FAQs
Yes, the choice of beneficiary is usually up to you, even though the purpose of the policy is to pay back your mortgage lender. Bear in mind that if your beneficiary doesn’t use the money to pay off the balance this will become the responsibility of your estate. Some lenders may stipulate mortgage insurance – with them as the beneficiary – as a condition of giving you the loan.
It certainly isn’t designed to do so. If correctly administered it will decrease in line with the outstanding mortgage, so that the policy will end when the mortgage repayments end. If the insured dies before the loan is paid off there should be just enough in the payout to settle the debt. If for some reason there is an excess this is an unplanned bonus and you shouldn’t expect it to materialise.
Technically you can’t normally convert one into the other, but there’s no reason not to cancel a mortgage life insurance policy and replace it with life insurance. Since mortgage protection policies don’t build up any cash value you won’t be losing anything by switching. The only thing to look out for is any kind of charge, penalty or fee for cancellation.
Not unless your mortgage provider insists on it as part of your mortgage contract. Without that obligation it’s entirely up to you whether you protect your mortgage or not. If you’re single with no dependents and no one to leave your assets to, you might not be bothered about your lender repossessing your home should you die. But for everyone else it may be a wise thing to do.
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