A dangerous mistake you shouldn't make

Life cover is essential if you have dependants, but the message still isn't getting through to a third of mortgage borrowers.

A new report from independent financial research company Defaqto, reveals one-third of borrowers fail to buy life insurance to cover their mortgage. In 2009, the Council of Mortgage Lenders recorded 925,000 new home loans, but the Association of British Insurers said only 636,973 new mortgage-related insurance policies were taken out during the same year.

That’s a shortfall of more than 288,000 policies. Of course, not all borrowers need life insurance. If there’s no-one in your life who depends on you financially then there’s little need for life cover. That said, single people - as well as people with partners and/or children - should take precautions to protect themselves against loss of income through illness, accident and unemployment.

In this instance, mortgage borrowers should consider taking out a critical illness policy or income protection insurance (sometimes known as permanent health insurance). For a comparison of the two products, check out Why it's vital to protect your income.

But even discounting those people who don’t need life cover, a significant protection gap remains.

Why do you need life insurance?

An alarming number of people are taking on mortgage debt with no means of paying it back should the worst happen.

If you have a mortgage with your partner, think of the financial consequences of one of you dying. The surviving partner would be left with the huge burden of the mortgage debt which he or she would be solely responsible for, unless an adequate amount of life insurance is in place. This could force him/her to sell your family home at the very worst moment imaginable.

At the very least, if you have a joint mortgage with a partner, you each need to take out your own life insurance policy with a sum assured (that’s the amount your life is insured for) which is at least equivalent to the mortgage debt. This will then guarantee the mortgage will be completely cleared in the event of one partner’s death, meaning the surviving partner can keep the roof over his/her head.

Don’t buy a joint policy

The chances are, if you have a joint mortgage with your other half, it probably seems logical to protect yourself with a joint life cover policy. But these actually offer rather poor value for money in comparison with buying two single policies.

Imagine this: Joan and Julian have a mortgage of £150,000 and buy a joint life policy to cover their joint mortgage for 25 years. After 20 years, Joan dies, and Julian makes a claim under the policy, receiving a payout of £150,000. However, even though it's a joint policy, a claim can only be made once, on the first death. So, once Julian makes his claim for Joan's death, the policy expires. This leaves Julian with no life insurance whatsoever, despite the fact that he and Joan have been paying almost twice as much for joint cover for 20 years than they would have paid just to cover Joan alone.

By contrast, if Joan and Julian had each bought a separate, single life policy, they would each be covered for £150,000. So when Joan dies, Julian can clear the mortgage using the cover provided by her individual policy. But Julian's own life cover will remain in place and can be claimed by his children, for example, should he also die within the term of the policy. Thus the total payout would be £300,000, not £150,000.

The difference in premiums for one joint life policy with a maximum sum assured of £150,000, compared with two single life policies with a maximum sum assured of £300,000 (in total) is surprisingly small.

For example, if you and your partner took out a joint life policy, the cheapest premium on the market today would be £19.17 a month (assuming you're both age 35 and don't smoke). But two separate policies come to £19.57 a month (see the table below) which, while costing a few pennies more, provides double the cover.

That's why I think two single cover policies are always better than one joint cover policy.

I can’t afford life insurance

Life insurance is cheaper than you might think especially if you’re reasonably young and in good health. The policy I’ve been talking about is known as level term assurance, and it’s designed to provide a constant amount of cover over the policy term.

In this example, the sum assured under the policy is £150,000 and it matches the mortgage term of 25 years. The table below outlines the most competitive costs for men and women age 35 who don’t smoke:

Level term assurance premiums

A woman can insure her life for little more than £100 a year, while a man would pay slightly extra at just over £130. Women pay a bit less for life cover because their life expectancy is higher than men’s, and therefore they’re deemed less likely to make a claim.

The costs for life cover is significantly less than you would pay to insure your car for instance. (Although the chances of claiming on a life insurance policy are far, far lower than a car insurance policy). Remember this small annual outlay provides both partner’s with £150,000 of life cover for the next 25 years.

Decreasing term assurance

If your budget is tight and the premiums above aren’t affordable, you could still insure your live with a cheaper type of life insurance. Whereas level term assurance provides a constant amount of life cover, you could use a decreasing term assurance policy where the cover reduces over time, bringing the premiums down. So, you can use decreasing term assurance to provide an amount of cover which drops in line with your outstanding mortgage debt.

The table below gives an idea of how much lower the premiums could be:

Decreasing term assurance premiums

This time, the premiums could be less than £80 a year for women and under a £100 a year for men. Just bear in mind, if you choose a lower cost decreasing policy, there will be no surplus cash if a claim is made as the mortgage alone will be cleared.

However, with a level term assurance policy, there’s a good chance extra money will be available to the surviving partner once the mortgage has been paid off, because the amount of cover always remains the same, but the outstanding mortgage debt is gradually falling.

I’ll finish by saying your mortgage is not the only expense you need to cover. There are 11 reasons why you need more protection. 

Compare life insurance quotes at lovemoney.com

More: Buy life insurance while it’s still cheap | Save 35% on life insurance