Mortgage life insurance is a type of life insurance policy that helps your spouse and/or dependants cover the mortgage payments if you die before you have paid it off in full. This protects them as it means they will still have a roof over their heads should the worst happen.
It is also known as mortgage protection, or sometimes mortgage insurance, but should not be confused with mortgage payment protection insurance (MPPI), which only covers your payments if something happens that prevents you from working, for instance long-term sickness or redundancy.
Once you or your dependants have made a claim, the policy ends. If you pay into the plan and never need to make a claim (which would be the case if you pay off your mortgage before you die), you will not get anything back at the end of the term.
There are two main types of mortgage life insurance that work slightly differently from one another. Whichever one you choose, be sure to do your homework and your price comparisons first. You do not need mortgage life insurance to qualify for a mortgage - although it is a sensible option for many borrowers. And any mortgage life insurance recommended by your mortgage lender or broker will likely be very costly because of the amount of commission they make should you take it.
Level term insurance allows you to choose the size of the payout – £200,000, for example – which is then fixed for the duration of the policy. The premiums (that is, the monthly payments) also remain the same, potentially making it quite a costly option.
If you were to die, your family would receive the lump sum and the policy would finish. The payout can then be used to pay off the mortgage, and if there is any left over, cover other household bills or even pay for your funeral.
Level term insurance could be a particularly good option if you have an interest only mortgage because the mortgage debt itself is unchanged for the duration of the term.
Decreasing term insurance covers a debt that is dwindling in size. If you have a repayment mortgage (where your monthly payments pay off the interest and some of the capital), then the amount you owe reduces over time.
Your payout reflects the reduction in your liability and so it too shrinks, as do your premiums. This makes it a cheaper form of insurance than level term insurance, but it does mean that towards the end of the policy’s life, the potential payout will be much smaller than at the beginning. It is designed to pay off your mortgage and no more.
Critical illness cover is an optional add-on to your chosen mortgage cover. The younger and healthier you are when you arrange the policy, the cheaper it will be. As you get older, it can become very expensive to arrange critical illness cover because, statistically speaking, you are more likely to become ill.
Critical illness cover pays out a lump sum if you are diagnosed with a serious condition, such as cancer or dementia, or experience a life threatening event such as a heart attack or a stroke. However, the policy will only pay out if the illness is listed in the policy, so it is important to read the small print. Not all providers and policies cover the same illnesses – so if you are not sure, ask!
Another reason an insurance provider may not pay out is if you have an illness (or a family history of one) that you did not disclose when you first took out the policy. If the insurer can prove you were guilty of “non-disclosure” you will get nothing, so it is really important you are 100% honest and accurate when giving the insurer details about your health.
Mortgage life insurance is useful for people who are married, in a civil partnership, or are cohabiting and could not afford the mortgage repayments with a single income. It is also useful for anyone with dependants, whether they are children, elderly relatives, or anyone else who relies on you financially, or with whom you share your home.
“If you are a single person with no dependants, you may not need life insurance for your mortgage,” says Mark Homer, founder of Progressive Property. “It is designed so that if one of the borrowers dies, the mortgage will be paid off. However, as a single person, critical illness cover could be useful, as it could help you if you were unable to work due to illness.”
Homer says that buying level term insurance can sometimes be worth the extra expense, even if your mortgage debt is decreasing: “The lump sum would pay off the mortgage, or be used for other expenses, in the event of your death,” he says.
If you have a buy-to-let mortgage you do not necessarily need insurance, even if you are ill, because the mortgage should usually be covered by the tenant’s rent. And if you were to die, the property would have to be sold or remortgaged anyway.
When it comes to choosing the term of a mortgage life insurance policy, most people time it to end at the same time as their mortgage. However, Homer suggests a smarter plan would be to take out cover for as long as possible.
“You might have a mortgage term of 20 or 25 years, by which time you might have paid the mortgage off,” he says. “If you are young and you take a policy out for 30 years then it will cost more per month, but over a longer period you will end up having something which is cheap. This is because as you get older, you are more likely to have special terms imposed and higher premiums.”
Simply put, if you die before you have paid off your mortgage, the debt is passed to your heirs, which could mean they need to sell your property. However, if you have some kind of mortgage life insurance, the mortgage debt is paid for you, and anyone who lives in the property can stay put without worrying about meeting the mortgage payments.
What happens to the insurance payout itself is a little more complicated, though. If you die with a mortgage life insurance policy, your heirs receive the payout, but they might be charged inheritance tax (the standard rate is 40%), which applies on sums above £325,000.
For example, if you had a level term mortgage life insurance policy of £400,000, your beneficiaries would have to pay 40% inheritance tax on £75,000 (£400,000 minus £325,000), costing them £30,000.
One way to avoid this is to have the insurance policy written into trust. Then, any payout your heirs receive will not be treated as part of your estate and so they will get the full payout tax free.