The difference between life insurance and mortgage life insurance

Why insurance is important

Insurance has existed for as long as humans have lived, traded goods, sold services and owned possessions. It doesn’t save lives or prevent the theft or destruction of property, but it does provide money to compensate for loss. That’s the essence of insurance, whether we’re talking about vets’ bills, missing luggage and stolen phones or liability for car accidents, the cost of private health and the loss of a loved one.

Insurance falls broadly into two categories: general and protection. Protection insurance essentially means life insurance or any insurable risk that’s entirely financial, such as income protection. General insurance covers everything else.

Life insurance and mortgage protection are two forms of protection insurance. In many circumstances they are virtually interchangeable, designed for similar purposes; but while all mortgage protection is life insurance, not all life insurance is mortgage protection.

Understanding life insurance

Here’s a brief overview of life insurance

What is it?

It pays out a lump sum on the death of the insured individual (usually but not always the policyholder). Its purpose is to give financial support to family and dependants whom the insured leaves behind.

What are the different types of life insurance?

There are many variations on this central idea. Perhaps the most notable are those that provide fixed or variable levels of cover:

Level: the payout and premiums remain the same throughout the policy

Decreasing: the payout reduces over the life of the policy (although the premiums don’t)

Increasing: the payout and premiums increase over the life of the policy.

There are also fixed length policies and open-ended ones:

Term life: insurance cover lasts for a pre-agreed time, such as 30 years.

Whole life: insurance cover lasts until the end of the insured’s life.

What is life insurance used for?

Income

The most obvious use is to provide money for people left behind, perhaps because they would struggle without the deceased’s income, or simply to give them a financial boost.

Expenses

The proceeds from a life insurance policy can be used to cover significant future costs, such as school or university tuition fees.

Debts

They can also be used to pay off any outstanding loans that survive the deceased, which brings us into the territory of mortgage life insurance.

Understanding mortgage life insurance

What makes life insurance for mortgages a separate concept?

What is it?

It’s insurance taken out on the life of an individual (normally but not necessarily the policyholder) specifically designed to pay off an outstanding mortgage should the mortgagor (the person who borrows the money) pass away.

How it works

Mortgage protection often takes the form of decreasing term life insurance. With a policy of this kind, the final payout decreases over time. This is because the outstanding balance of a repayment mortgage also decreases until it’s fully paid off. It’s impossible to know when you take out a mortgage loan how much will be repayable, since interest rates fluctuate. For that reason, decreasing mortgage protection policies are regularly reviewed to ensure they’re neither falling short of their purposes nor generating a larger payout than the insured wants.

Decreasing term insurance isn’t the only form of mortgage protection. You can choose level or even increasing if you wish and in both cases there may be money left over to pass on to dependents. As long as you can be sure the policy will produce sufficient funds to pay off the mortgage loan, it should do its job.

One important question when setting up mortgage life insurance is the identity of the named beneficiary. It’s common for the lender (the mortgagee) to be named in the policy. There’s no legal obligation to do this, but some lenders may require it as a condition of granting the loan. This may not be ideal because it can make it hard for the policyholder’s heirs to take control of any funds left over after repayment of the mortgage.

It's also common for the beneficiaries to be relatives or friends of the insured. In these cases the funds won’t go directly to the lender but will have to be transferred to them by the beneficiaries. This doesn’t usually create any difficulties, since the debt will otherwise pass into the estate of the deceased and become the responsibility of the beneficiaries anyway.

How is mortgage life insurance used?

The principle of its operation is always essentially the same although it can lead to slightly different outcomes as a result of other factors, legal and otherwise. Let’s consider a couple of examples.

1.     A married couple buys their home jointly with a 30-year repayment mortgage. They are joint tenants, which means if one dies the home becomes the property of the other automatically, without formal inheritance, probate or tax.

The husband takes out decreasing mortgage life insurance to pay off the mortgage if at any point one of them passes away during those 30 years. The wife is the beneficiary.

The husband dies after 20 years. The wife is now the sole owner of the house, but she doesn’t own it outright because 10 years remain on the mortgage. She receives the payout, pays off the balance and becomes sole owner of the unencumbered property.

2.    A married couple buys their home jointly with a 25-year repayment mortgage. They are joint tenants.

They take out level term life insurance to cover the mortgage. Their lender is named as beneficiary.

They both die in an accident after 20 years. The life insurance policy pays out to the lender, who uses the proceeds to settle the outstanding loan.

The house passes into the couple’s estate and is inherited - unencumbered but subject to inheritance tax - by their children according to their will.

Mortgage life insurance vs life insurance: the main differences

Purpose

Perhaps the biggest difference between life insurance and mortgage life insurance is the purpose for which they’re taken out. Life insurance is usually intended to give general financial support to family, dependants and friends. Mortgage life insurance is specific to the imperative of paying off the mortgage loan if the borrower dies.

Cover

Life insurance can have level, decreasing or increasing payouts and can last for the lifetime of the insured or for a fixed period. Mortgage life insurance is much more frequently chosen in the form of decreasing term insurance.

Joint or single

Both life insurance and mortgage life insurance can be set up as single or joint policies.

Beneficiaries

The policyholder can choose the beneficiaries of their life insurance policy. The same is true for mortgage protection although it’s common and usually neater to name the lender as beneficiary. Some lenders may make this a condition of the mortgage contract.

Flexibility of payout

The proceeds of a life insurance policy can be put to a broad range of uses, while the payout from mortgage life insurance is narrower in scope. Its purpose is solely to pay off the outstanding loan. Any funds left over can be transferred to other beneficiaries or family and friends, but in most cases there will be little or nothing left.

Cost

Mortgage life insurance is generally a cheaper option – certainly if it is a decreasing term policy – because its diminishing nature means that, although the premiums don’t decrease, they are lower than level or increasing term policies, both at the start and throughout.

The pros and cons

Finally, if you’re unsure whether to take out one or the other – or even both – it’s worth weighing up the advantages and disadvantages of each.

Life insurance

For:

It can provide financial help for circumstances beyond mortgage repayments, such as the future expenses of your family, both known and unknown.

Against:

The premiums are generally higher than mortgage life insurance and if you choose an increasing term policy they will increase.

Mortgage life insurance

For:

It’s less expensive than standard life insurance

With regular reviews it’s guaranteed to pay off your mortgage

Against:

It’s limited to repaying your outstanding mortgage so is unlikely to yield any excess funds.