The aim of life insurance is generally to ensure that the policyholder’s dependants – their wife or husband, and any children – can cope financially in the event of their death. So the cover is often set up to ensure that the bereaved family can continue to meet vital living expenses.
Most people looking for life insurance will attach greatest importance to ensuring their dependants can keep the roof over their heads, and as a result many life insurance policies are taken out specifically and solely to cover mortgage repayments.
It is possible simply to set up a standard life policy which covers the same amount as the outstanding mortgage. But another, potentially cheaper, option for those who are concerned principally with making sure there is no risk of the family home being lost is to take out a dedicated mortgage life insurance policy.
How is mortgage life insurance different?
The most comprehensive type of life insurance, whole-of-life cover, guarantees to pay a fixed sum irrespective of when the policyholder dies. But a different type of protection, called term insurance or term assurance, only pays out if the policyholder dies within a pre-agreed timeframe. Mortgage life insurance is a type of term insurance, and the benefits it offers are designed to match the policyholder’s mortgage commitments for however long the loan has to run.
This means there are normally two main differences with this type of policy:
It only lasts until the mortgage is paid off. So if you are signing up for a 25-year mortgage when you buy your life insurance, its term should also be 25 years.
The potential benefit falls every year. If you have a repayment mortgage, the amount you owe to your lender decreases with every monthly repayment you make. Mortgage life insurance is designed to match this mortgage commitment. For example, if you died in the second year, your payout would be significantly higher than if you died in the 20th year, as you would owe more to your mortgage lender.
Mortgage life insurance is a type of decreasing term insurance: you might see it described as such on product literature. Other things being equal, premiums on this type of cover are cheaper than on insurance which pays the same rate throughout the term.
What to watch out for
There are a few things to bear in mind when taking out mortgage life insurance. First of all, it may not be appropriate if you have an interest-only home loan, as the amount you owe the lender will not be falling year on year.
You should also ensure that the life cover always matches the term of your mortgage: many people extend their mortgage term when they move house, or simply to reduce the size of their monthly repayments. If this happens, talk to your life insurer to see if the policy can be altered to match.
Ensuring a speedy payout
When you take out a mortgage life insurance policy, it is also worth thinking about how to make sure your dependants can get hold of any payout with the least hassle and the lowest possible tax charge if the worst does happen. Writing your life insurance policy in trust means the cover is ring-fenced outside the rest of your assets, such as savings, investments and property. This means that payments from the policy are not included in your estate for inheritance tax purposes.
At the moment, inheritance tax is charged at 40 per cent on any bequeathed assets above the £325,000 threshold. So depending on the value of any property or investments you have, up to 40 per cent of a life insurance payment could end up in the taxman’s hands if the policy is not written in trust.
And because the life policy is not included in your estate, the payout does not have to go through the probate process with the rest of your assets, which means your family will probably get the money much more quickly.
This could be vital in ensuring that they do not fall behind on mortgage repayments and risk having their home repossessed. A trust is normally simple and cheap (or even free) to set up: talk to your insurer when you take out your policy, but bear in mind that a trust is not appropriate in all circumstances.