If you currently have a repayment mortgage then you may already have decreasing life insurance, or at least been given some information on it.
But how does a decreasing life policy work? And why are they used for repayment mortgages?
Our guide answers these questions and many more, as we analyse what these policies do and who can benefit from them.
What is Decreasing Life Insurance?
Decreasing life insurance is a type of life policy where the death benefit (sum assured) gets less as time goes on.
So if you die in the early years of taking out a policy, your family will receive more money than if you died in later years.
It is most commonly used to protect a repayment mortgage in the event of one of the borrowers dying early.
How does it work?
Let’s use a very simple example to help explain how it works.
Janet and John are applying for a £250,000 mortgage, repayable over 25 years. They have chosen a full repayment mortgage.
As they make their mortgage repayments each month, the amount they owe slowly goes down.
So, by taking out a decreasing mortgage life insurance policy, their cover should be enough to pay off this reducing debt. They would need to apply for a joint life policy, with a £250,000 sum assured which will reduce over 25 years.
How does the cover reduce over time?
There are two answers to this question:
mortgage related cover
A repayment mortgage does not reduce in a nice, predictable straight line.
It starts off very slowly, so in the first year or two you won’t have reduced the balance very much at all.
Most of your monthly payment will go to the lender as interest.
But as the mortgage term progresses, this changes and more of your money goes toward repaying the debt. In the final years virtually all of your payments are paying off capital.
Because of how a mortgage balance reduces, a mortgage life insurance policy needs to mimic the rate at which the debt is reducing, so that you have the right level of cover when it’s needed.
Your mortgage and life cover policy are completely separate from each other. This means that the insurance company won’t know who your mortgage is with, or what interest rate you are paying.
Because of this, the insurer uses an average interest rate to calculate the speed at which the life cover reduces. Often this assumed interest rate is somewhere between 7% and 10%. Therefore, if your mortgage interest rate is higher than this, the policy may not pay out enough money on death.
The exact figure will be shown on your insurance quote and many companies allow you to change this.
non-mortgage related cover
Insurers have designed two different types of policy where the cover decreases. One that protects a mortgage, where the cover reduction is linked to an interest rate.
And one that has reducing cover but is not used for a mortgage.
What’s the difference?
Primarily it is the rate that the cover reduces each year. A non-mortgage policy will see the sum assured (death benefit) go down in equal percentages each year, until it reaches zero.
Whereas the mortgage policy starts off more slowly.
The other difference is how the insurance company underwrites a policy. If you apply for a mortgage policy, but don’t have a mortgage, then the insurer may impose extra conditions or further information.
With a decreasing term policy you are only paying for cover you need. As your children get older, it’s likely that they will be less financially dependent on you. So the need for life cover slowly diminishes.
How much does it cost?
Decreasing term insurance is a very affordable type of life assurance policy.
The main reason is that the total amount of insurance that the policy pays out decreases from the start of the policy.
So the insurance company’s liability will reduce as each year passes.
By comparison, a level term insurance policy will always pay the total sum assured in one go, whether you die in the first year, or the last year.
The actual cost of a policy will depend on; the amount of cover, the policy term, your age, your health.
FIXED PREMIUMS
Policies generally come with fixed, or guaranteed, premiums. So you know exactly what the cost will be each month. This is a useful feature of term assurance plans.
| £250,000 | £300,000 | £400,000 | £500,000 | |
|---|---|---|---|---|
| Age 25 | £8.50pm | £9.60pm | £11.80pm | £14.00pm |
| Age 35 | £12.20pm | £13.99pm | £17.57pm | £21.16pm |
| Age 45 | £24.78pm | £28.97pm | £37.33pm | £45.70pm |
These premiums are for illustration purposes only. Cover shown is a decreasing term insurance, over 25 years. Male, non-smoker. Correct as at September 2023.
Who is decreasing life insurance suitable for?
Decreasing life insurance is suitable for individuals who have financial commitments that reduce over time and want to ensure that these are covered in the event of their death.
Here are some specific scenarios where decreasing life insurance might be suitable:
Repayment Mortgage Holders
This is the most common scenario. Individuals with a repayment mortgage (also known as a capital and interest mortgage) will see the amount they owe decrease over time as they pay off the principal. Decreasing mortgage life insurance can be tailored to broadly match the outstanding balance of the mortgage, ensuring that if the policyholder dies, the remaining debt can be paid off.
Individuals with Decreasing Debts
Apart from mortgages, if someone has taken out a personal loan or any other form of debt that they’re repaying over time, a decreasing life insurance policy can be used to cover the outstanding amount.
Parents with Dependent Children
While the primary use of decreasing life insurance is to cover debts, it can also be suitable for parents who want to ensure financial support for their children. As children grow and become financially independent, the financial burden on parents typically decreases. A decreasing family protection policy can reflect this diminishing need.
Individuals on a Tight Budget
Since the potential payout decreases over time, the premiums for decreasing life insurance are lower than for level term insurance (where the payout remains constant). For those on a tight budget who want to ensure coverage for decreasing financial commitments, this can be a cost-effective option.
Business Loans
Business owners or partners who’ve taken out loans that decrease over time might consider decreasing life insurance to ensure the loan can be repaid if they pass away.
Tax Planning
In some cases, decreasing life insurance might be used as part of inheritance tax planning, especially if the expected tax liability decreases over time. To cover the possible tax on a Potentially Exempt Transfer (PET), some advisers will suggest taking out a “Gift Inter Vivos” policy, which offers decreasing life cover.
However, it’s essential to note that decreasing life insurance might not be suitable for everyone. For instance, those with interest-only mortgages, where the principal amount remains the same, would be better served with a level term policy.
Level vs Decreasing life insurance
Before we look at how other policies compare, it’s worth reminding you that mortgage lenders don’t make you take out any life insurance (crazy eh!). Conversely, you don’t need life cover to get a mortgage.
What does this mean?
Well, this means that the type of cover and the amount of cover, is totally up to you. You have a free choice to buy the type of life insurance that you are happiest with.
So, how does decreasing cover compare with level cover?
- Firstly, it offers a lower amount of life insurance, as it reduces every year over the policy term.
- Secondly, the monthly premiums will be a bit cheaper.
Which one is best for mortgage protection?
It depends!
Decreasing cover
Provides the most cost effective option. Lower premiums and death cover that should be enough to repay a specific mortgage, but without any surplus money. If you change your mortgage amount, or the term, then you may find that the policy is no longer compatible. This might be called the basic cover.
Level cover
This is premium life cover. A little bit more expensive but as the life cover stays level it could provide protection even if you increase your mortgage slightly later on. If not, then your family will benefit from a cash sum above and beyond what is owing on your mortgage.
Taking out any form of life cover to protect a mortgage is a great idea. It’s just that the level cover idea is better.
Can you get a joint policy?
Yes, decreasing cover policies can be set up on an individual or joint basis.
As with other types of life insurance, the death benefit under a joint policy will be payable to the surviving policyholder.
The policy can only pay out once though.
This is known as ‘Joint life first death’. So when the first policyholder dies, the cover for the remaining policyholder will stop.
This is generally OK for mortgage protection.
To avoid this you would need each person to take out their own policy. This would be a bit more expensive but it does allow the surviving partner to keep the benefit of their own policy, without having to re-apply.
You will find more useful information in our article: “How does mortgage life insurance work?“
No. The death benefit payment from life insurance is not taxable.
A basic policy will not automatically provide cover for critical illnesses. However, most insurance companies will offer this as an option.
Decreasing mortgage policies are cheaper than level cover policies.
Term assurance plans have a fixed term. When the term ends, the policy and all associated cover, will stop. It will not have a cash value.
Most insurers do now include terminal illness insurance as a standard feature of life policies. However, if this is important to you, you should check the policy cover before making an application.
Yes, in line with other types of life assurance, a decreasing policy can be written into trust.
Sadly not. The insurance company will effectively charge you an averaged premium, for your decreasing life cover. So once the policy begins, your premiums with neither decrease or increase.
GIO, or Guaranteed Insurability Option, is included under many life cover policies, including those with decreasing cover. It allows the policyholder to increase their life cover in response to certain life events (marriage/new baby etc).
Not all policies will offer this, so if it is important to you, make sure you check the policy details before applying.
