When signing on for a loan, whether it’s a mortgage for a new home or a personal loan to consolidate credit card balances, you’re often offered insurance that promises to make the debt payments should anything happen to you.
At first blush this sounds like a great idea, right?
After all, such insurance is designed to step in and cover monthly loan payments and protect you from default in the event of anything from job loss to debilitating illness and even death.
While there are benefits to this type of protection, there’s also a long list of reasons to think carefully before signing on the dotted line, including the fact that there are better options out there that will protect you and your family more directly and thoroughly in the event of the unexpected.
The Types of Loan Insurance Policies Available
As the Federal Trade Commission (FTC) explains, there are several types of loan insurance (also known as credit insurance) available to consumers. Options include credit life insurance; credit disability insurance; involuntary unemployment insurance and finally credit property insurance.
None of these should be confused with private mortgage insurance, otherwise known as PMI, which is typically a requirement for homebuyers who put less than 20% down on a home purchase.
Among the drawbacks of loan or credit insurance is the decreasing value of the policy, says Kathleen Fish, a certified financial planner and president of Fish and Associates.
What does that mean exactly?
In the simplest sense, it means that you will always pay the same amount for your monthly premium despite the fact that the face amount or benefit offered by the policy decreases with each subsequent payment, explained Fish. She suggests that level term policies, which pay the policy’s full-face value for the life of the policy term, are often a better option.
Zhaneta Gechev of One Stop Life Insurance offers similar criticism of loan insurance and says she’s passionate about educating consumers regarding the drawbacks of such policies.
“For example, you start off with a $200,000 policy and you’re always paying the same premium. However, in X numbers of years, your policy could be worth half of what you started off with,” said Gechev. “Why pay the same price for lower coverage?”
Yet another important distinction to understand about loan insurance is who benefits from the policy. The answer is the bank or the lender, not you, and not your family members.
In other words, with a standard life insurance policy, for instance, you get to select the beneficiaries. “You get to name the beneficiary who can in turn pay off the loan and keep the difference,” said Fish.
But with loan insurance, the bank or lender is the sole beneficiary. To make this point clearer, if you pass away before your mortgage is paid off, for example, mortgage insurance will pay the balance owed on the home. That’s it.
“But this may not be what your family needs at that particular moment,” explained Gechev. “Your spouse or parents or children will need money to pay for your funeral. And as we all know, they are not cheap.”
Surviving family members may also need to pay medical bills and other expenses.
“To me, as a consumer, I want to keep control of the decision about how the money is spent,” continued Gechev. And by opting for loan insurance rather than a traditional life insurance or disability policy, you lose that control because the beneficiary is the lending institution.
For all the money you pay into loan insurance, there’s no guarantee it will actually cover you in a time of need, says Angela Bradford, of World Financial Group.
“The companies decide at the time of the claim if the person was insurable. They don’t always pay out,” she said. “Most are set up this way. At the time of something happening is when the company decides if they’re going to pay out the loan or mortgage… If the client had past health problems, the companies get away without paying out.”
To help avoid this pitfall, before signing up for a policy ask about the company’s underwriting procedures, specifically whether policies are underwritten when applied for or when claims are filed, said Sarah Jane Bell, a financial advisor with Sun Life Financial.
“Often it’s underwritten after a claim, so if you had a medical issue not disclosed upon applying, the claim can be denied even after paying premiums along,” Bell said.
You May Already Have the Coverage You Need
Many consumers fail to realize that they already have the coverage necessary to pay a mortgage or some other loan in the event of an emergency.
This coverage comes in the form of other policies (think: life insurance, disability insurance) and often, those other policies have the added benefit of not requiring the funds be used solely to pay off your loan, as already discussed.
“When shopping for loan protection insurance, first review your current life insurance, disability insurance, and other coverage to see if you really need additional coverage for your loan,” suggests Kathryn Casna, an insurance specialist with TermLife2Go.com.
Most employers, for example, offer employees the option to sign-up for short-term disability and unemployment insurance during the on-boarding process, and may offer long-term disability policies as well, Casna said.
At a Minimum, Shop Around
If you still decide that a loan protection policy is the best approach for you, it’s important to shop around, identifying the best price and the right coverage for your situation.
Many loan protection insurance plans cost around 0.2% to 0.3% of the loan or mortgage, said Jared Weitz, CEO and founder of United Capital Source.
“The price will vary based on the duration of the plan, the size, and the level of coverage,” Weitz explained.
Also, as part of your research process, make sure you’re getting the right type of policy, said Casna.
“Credit life insurance pays out only if you die. Credit disability pays out only if you can’t work due to a disability, while involuntary unemployment insurance pays out if you lose your job for any reason that’s not your fault,” Casna explained.
Review your policy carefully to ensure it will cover your concerns. Some credit disability policies, for instance, won’t pay out if you work part-time, are self-employed, or your inability work is due to a preexisting health condition.
“Read the fine print before signing up, you need to be aware of what the policy actually covers and under what grounds you’re able to file a claim,” said Weitz.
Mia Taylor is an award-winning journalist with more than two decades of experience. She has worked for some of the nation’s best-known news organizations, including the Atlanta Journal-Constitution and the San Diego Union-Tribune.