Mortgage life insurance covers your mortgage payments should you die before you have paid it off fully, and allows any joint mortgage holders or dependants to remain in the property.
What is mortgage life insurance?
Mortgage life insurance is a type of life insurance policy that helps your spouse and/or dependants cover the mortgage if you die before you have paid it off in full, meaning they will still have a roof over their heads should the worst happen.
It is also known as mortgage protection, 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.
How does mortgage life insurance work?
There are two 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. 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
Level term insurance allows you to choose the size of the payout – £200,000, for example – that is then fixed for the duration of the policy. The premiums (that is, 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 be used to pay off the mortgage and if there is any left over, cover other household bills and 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
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 pay out would be much smaller than at the beginning. While the payout would cover your mortgage, it might not stretch beyond that.
Critical illness cover
Critical illness cover is an optional add-on to your chosen insurance policy. 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, like cancer or dementia, or something life threatening happens like 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 – 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 – it could simply claim “non-disclosure” and you would get nothing, so it is really important you are 100% honest and accurate when giving the insurer your health history.
Do I need mortgage life insurance?
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 that is 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 then you may not need it,” 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 is helpful, even if you have a mortgage debt that 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 is covered by the tenant’s rent. If you were to die, the property would have to be sold or remortgaged anyway.
How long should a mortgage life insurance policy last?
When you are choosing the term of the mortgage life insurance policy, you might decide to time it to end at the same time as your 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.”
What happens to my mortgage if I die?
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 they, if living in the property, can stay put.
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.
Any payout your heirs receive will not be treated as part of your estate and so they will get the full amount of the policy.
Edited by: Sarah Guershon
Image credit: Simon Matzinger/Pexels