Most of us have some type of debt, some more than others. But have you ever considered what would happen to these debts should you die?
If you also have a life insurance policy it seems reasonable to assume that this would be used to pay off the debts.
But does life insurance always have to be used to pay off debt? Actually no it doesn’t.
Let’s take a look at how it works.
What happens to your debts when you die?
Your debts remain fully repayable, even after death.
So any personal loans or credit cards you may have, all need to be settled, together with the mortgage balance.
Any liquid assets you may have (cash, shares etc) could be used to pay off unsecured debts, like cards and loans.
But this is not normally possible with a mortgage, just due to the size of the debt.
For this reason, many borrowers take out some life insurance so that the mortgage gets repaid should they die.
You will find more useful information in our article: “What happens to a mortgage when someone dies?“
Who is responsible for paying off the debts?
The people responsible will be slightly different depending on if you were single, married and whether you had a will.
Debts held in joint names, like a mortgage, will pass to the surviving borrower, who is then solely responsible for the debt. In the UK, the lender has the right to request the full repayment of the loan upon the borrower’s death. Although this rarely happens as they will be sympathetic to the situation of losing a loved one.
But broadly, it is the duty of the executor or administrator of your estate to fully pay off debts. They will be able to use savings, investments and other assets to pay off creditors.
Life insurance and mortgages
If you have a joint mortgage, or provide a home for your family, you may at some point have looked into life insurance.
Mortgage life insurance can be used to protect a mortgage against the death of a borrower.
Without this, the remaining family member would need to keep up the monthly repayments, and ‘take over’ the mortgage debts.
If this is not possible, or is unaffordable, then they will most likely have to sell the home and move somewhere else.
Mortgage specific policies are available:
Decreasing mortgage life insurance – The death cover reduces each year, so it is most suitable for protecting a repayment mortgage.
Level mortgage life insurance – The death cover stays the same (level) each year, this policy can protect any type of mortgage.
Separate arrangements
You may be surprised to hear that your mortgage, and your mortgage life insurance, are completely separate from each other.
While the life cover element is designed to work with a mortgage, it does not form part of it, and is solely independent.
Should you change your mortgage, you are not obliged, to inform the insurance company. And vice versa.
So does life insurance have to pay off debt?
No, not at all.
A life insurance policy will pay out the sum assured on death, as a tax-free lump sum. This will be paid to your estate, not direct to a mortgage or loan company.
How it is then distributed will depend on your family and the executors of your estate.
While the primary aim of mortgage life insurance is to fully repay the debt. It is also possible for your family to put the money into a savings account (or spend it!) and then keep making the monthly repayments.
Family Protection
This would certainly be the case for a family protection policy, which is normally set up in addition to mortgage cover.
Here, the payment is for the surviving family, so that they have a degree of financial security.
If the payment is from a level term insurance plan then often the lump sum would be invested so that it generates a regular income.
Whereas a family income benefit policy will only pay out a set monthly income for a set number of years.
Inheritance Tax (IHT)
Inheritance Tax (IHT) is a government tax levied on the estate (including property, money, and possessions) of someone who has passed away.
We are not going to explore how the tax is calculated but you should know that:
A life insurance payment will increase the value of your estate on death.
If you have a life policy in your sole name, then upon your death the insurer will pay the death benefit to your estate. The executors will then decide what to do with it.
This payment could cause your estate to be liable for inheritance tax, and this tax would be paid from the policy pay out.
But this situation can be avoided.
You will need to take some advice so that any arrangements are suitable for you.
But you could:
Have someone else own the policy
They would own the policy but you would be the one covered. Upon your death the payment will be made to the policy owner, completely avoiding your estate.
This is called “life of another”. Suitable policy owners would be a partner or companion.
Put the policy in to trust
A trust is a legal wrapper that will then own the policy and any money that it generates. Again, upon your death the sum assured will be paid to the trust, not to your estate.
The trust will have trustees and beneficiaries, who you will have selected.
It’s very easy to set these up incorrectly. Speak to an expert for guidance.
Going through the financial implications after a loved one’s passing can be challenging and upsetting.
It’s important to understand that all debts, from personal loans to mortgages, remain repayable even after death. While liquid assets can address some of these, mortgages often require additional considerations due to their size.
Life insurance, especially mortgage-specific policies, can offer a safety net, ensuring that surviving family members aren’t burdened with large debts. However, it’s crucial to distinguish between mortgages and life insurance, as they operate independently.
Additionally, while life insurance can provide financial relief, it can also impact the estate’s value, potentially subjecting it to Inheritance Tax. Strategies like placing the policy in a trust or the “life of another” approach can help mitigate this.
Given the complexities, seeking expert advice is paramount to ensure that all arrangements align with your financial goals and provide the desired protection for loved ones.
