There has always been a very close relationship between mortgage loans and life insurance. When you borrow a substantial sum of money to buy a home, you enter into a long financial commitment which will bind you for years or even decades. A long-term insurance policy that has been calculated to cover the outstanding debt gives much needed certainty to you, your family – and your lender.
Although financial advisors and mortgage brokers might present you with all kinds of loan options, there are basically only two types of mortgage: repayment and interest only. Life insurance plays a significant role in each, but in significantly different ways.
With this kind of mortgage, you borrow the sum you need for the property purchase. This sum is known as the capital. Your monthly repayments are made up of two parts. Firstly there is a small proportion of the capital and secondly, there is the monthly interest on that capital. Although the level of your monthly payment won’t usually go down over the term of the mortgage you’ll notice that the outstanding amount you owe does gradually reduce.
As the name suggests, the only thing you pay to the lender during the life of the mortgage is the monthly interest. This means that you’ll probably be paying smaller amounts each month but the disadvantage is that at the end of the term you will still have to pay back the full amount of the capital borrowed.
It’s not so much a question of whether you need it, more a matter of doing what is most effective to ensure the loan is paid off and, in many circumstances, to protect your family.
If you have a repayment mortgage then at the end of the mortgage term the entire loan and interest have been paid off and you’ll own the property outright. However, what if something unexpected happens? You might lose your job and experience a drop in income. You might become ill and unable to work. Many lenders will try to help you find a way round these setbacks and there are mortgage payment protections you can buy, but in the worst case, you might die leaving the debt partially unpaid. If that happens and even a proportion remains of your mortgage, life insurance will come to the rescue. The rest of the loan can be repaid from the proceeds of the policy and your family won’t have to find the money or give up the property.
A particularly useful kind of support is offered by a decreasing term life insurance policy. This kind of policy is designed to follow the movement of your capital debt so that as the amount outstanding decreases, so does the amount of cover because its sole purpose is to pay off the capital should you die before the end of the term. It will be sufficient to pay what remains but there won’t be any money left over to leave to family. The advantage is that this is an economical way of getting mortgage protection.
If you have an interest-only mortgage then as part of the arrangement you will have to show the lender that you have a method in place to pay off the capital at the end of the term. Once upon a time, you could rely on the sale of the property to pay off the debt but this is no longer always accepted. You must have some reliable, guaranteed source of funds. In the 1980s and 90s endowment policies became very popular. These are a combination of life insurance and investment vehicle but they were discredited as a result of mis-selling and poor performance. Today they are comparatively rare, mainly because they don’t necessarily provide good value for money.
It makes more sense to take out a policy that has just the one purpose of paying off the capital. If you insure your life for the full amount you borrow, then you have the certainty of knowing it is covered, whatever happens in the investment market.
Endowment policies, as we’ve discussed, tried to do two things and often failed on both counts. They tried to cover capital borrowing and also perform as an investment. This made them vulnerable to the fluctuations of the stock market, which by the end of 1990s was performing poorly. We’ve seen since – in 2007 – how things could get even worse so it’s a brave person who would consider an endowment mortgage today.
However, just because endowments turned out not to be a good idea, that doesn’t mean the concept of multi-purpose policies is dead. If you want to keep it as simple as possible then by all means take out life insurance designed purely to cover the outstanding debt at any particular time during a repayment mortgage or to cover the entire loan at the end of an interest-only mortgage. But if you want your life insurance to work harder for you and you’d like this long-term financial commitment to provide for multiple outcomes, you can certainly do this.
What you need is a life insurance policy that can exist independently of your mortgage. Paying off the debt will be the primary aim, but needn’t be the only one. Let’s look at the differences between term life insurance and whole of life insurance.
We’ve already seen a version of this in the context of interest-only mortgages. There, the policy is set to mirror that of the mortgage term and both will end together. However, there is nothing to prevent you from taking out a separate longer-term policy. In this way, you could guarantee the repayment of, for example, a 25 year loan, on maturity of the shorter term insurance, but continue the second policy for another 10 or 20 years.
That approach could provide for dependents and family above and beyond protection of the home. Even if you have children who are well into adulthood by then, you may still wish to give them a financial boost if you should die. The same goes for the spouse you leave behind.
This type of policy has only one termination date – the day you die. That is its huge advantage – your family knows they will definitely receive financial help when you die, at whatever age that might be. The disadvantage is that whole of life policies tend to be much more expensive, largely because the insurance company is committed to paying out eventually, which means they can’t gamble on risk.
These are the key points of difference:
Although the only person who cannot benefit from the eventual pay-out is the person insured, anyone else can be named as a beneficiary. Provided that the insurance policy has been correctly written, it will not form part of the insured’s estate and its proceeds can therefore be distributed to its beneficiaries independently of a will and without needing a grant of probate. This also means it won’t be subject to inheritance tax.
For this reason, life insurance is an excellent way to lessen the impact of inheritance tax on your estate. At present when you die, only the first £325,000 of your estate is exempt from tax. In March 2022 Rightmove, the online estate agency, calculated that the average price of a home in the UK had risen about £350,000 for the first time . In that context, the inheritance tax threshold is swallowed up by property, leaving everything else liable to tax at 40%. A generous life insurance policy can make a significant difference to the amount your beneficiaries will have to pay.
However, there are happier things that life insurance can help with. Obviously it plays a major part in buying a property and giving you the freedom that home ownership entails. If you are planning to marry and therefore combine assets, it is an excellent way of making sure your spouse is protected, and the payments you make during your life will continue to benefit them after you’re gone.
Marriage is often the prelude to starting a family and raising children is expensive. According to the Child Poverty Action Group, the cost of looking after a child up to the age of 18 in 2020 was £71,611 for two parents and £97,862 for a single parent family . The proceeds of a life insurance policy would give more than a helping hand to a surviving partner and while nothing will compensate for losing you, it will certainly make the life of your spouse and children much easier.
Being able to help with your children’s future is an important part of being a parent. Some of us are in the happy position of being able to give plenty of financial help to them during our lifetime. Some people can absorb their student debt, provide the money for a deposit on a flat or a house, and generally support them as they set out on their own path. By no means every parent can afford to do this, but by taking out a life insurance policy, you can provide help after death and you’ll have the comfort of knowing that if the worst should happen, your children, whatever their age, will see some benefit from a sad event.
Another consideration related to your passing is the funeral arrangements. There is tremendous peace of mind to be had in knowing that, when you die, your loved ones will not have to assume the burden of paying for the funeral. Compared to other major family milestones, funerals are not the most expensive, but according to British Seniors Funeral Report 2021, the average cost of a funeral is about £5,600. Even a modest policy would cover this.
As you can see, life insurance can do more than protect your mortgage. The amount of assistance it can provide depends on how much you can afford to spend on premiums. The type and length of policy are also material factors as are any extras you might want to add such as critical illness cover or specific funeral benefits. The best place to start is with our life insurance calculator. All you have to do is answer a few questions about your objectives and the size of premiums you could manage and you’ll receive an almost instant indication of the policy options most suitable for you. It’s important to enjoy life to the full, while planning for every eventuality.
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