Does my life insurance cover my mortgage?

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by: bythesea
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Date: Sat, 11 Sep 2010 Time: 11:20 PM
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Homeowners who have switched to interest-only mortgages to cut monthly outgoings could be putting their life insurance cover at risk. The Financial Services Authority (FSA) recently estimated that over the past five years, up to a third of mortgages in the UK have been interest-only loans, where borrowers don't have to repay any of the capital until the end of the deal. But many life-insurance policies taken out alongside mortgages will not fully cover the loan if it is changed to interest-only, as we explain below.

Over the past decade, more and more homeowners have been choosing interest-only deals as a way of coping with rising repayments, or because this has been the only way they could afford a mortgage.

Changing from a repayment to an interest-only mortgage can also be an option if there is a fall in family income, through redundancy, say, or if the cost of other outgoings increases substantially.

A short-term solution

Moving to an interest-only mortgage can solve a cash-flow problem in the short term. But, as the FSA and other debt groups warn, the capital advanced to fund a house purchase will have to be paid off at some point down the line.

It is vital, therefore, that borrowers have some plan in place for making this repayment - for example a separate savings account, or a stock market-linked investment.

The life insurance problem

One little-known issue about switching from a repayment mortgage to an interest-only deal is the effect this can have on any life insurance policy which is linked to the loan.

Taking out a mortgage is a common time for people to sign up for life insurance: the policy is designed to ensure the surviving family can pay off the mortgage - and keep a roof over their heads - in the event of the main earner's death.

A lot of mortgage-linked policies offer a decreasing level of cover as time goes by: this is because the size of the debt normally falls over time as borrowers pay off more and more of the capital.

But if the mortgage changes to interest-only, the capital is no longer being paid off - even though the life cover is still falling every year.

As a result, any life insurance payout is unlikely to fully cover the outstanding balance of the mortgage.

Anyone who has switched to an interest-only loan, therefore, needs to check that they have enough cover, and change their life insurance policy if not.

Alternative policies

Mortgage repayments are not a family's only expense, so it could be worth insuring a greater proportion of income.

Life cover does not have to be limited to paying off a home loan: the scope of cover can be extended so that normal family outgoings are secured, for a number of years at least, if the main breadwinner dies.

There are other types of protection policies as well: income protection will pay out if the main breadwinner loses their job, or becomes too ill to work. Critical illness cover kicks in if a serious illness, such as stroke or cancer, are diagnosed.

As redundancy and illness are both more likely to happen than death, these policies will, however, be more expensive than life insurance.

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