Life Insurance for an Interest-Only Mortgage
An interest-only mortgage is the one case where the common advice about mortgage protection is actively wrong.
Most mortgage cover is sold as decreasing term, which falls over time to track a repayment mortgage. On interest only nothing is being repaid, so the debt sits at the same figure for twenty years and then falls due in full.
A decreasing policy against a flat debt is a gap that widens every single year, and it is one of the more common mismatches we see.
The short answer
On an interest-only mortgage the capital is exactly the same on the last day as it was on the first, so cover that decreases over time is the wrong shape entirely. Level term cover matching the full balance for the full term is usually what fits, and the repayment vehicle that is supposed to clear the debt deserves as much attention as the insurance.
What this changes
- The capital you owe does not reduce at all over the term
- Decreasing term cover, which is what most people are sold, falls away underneath it
- There is supposed to be a repayment vehicle, and it may be an investment that can fall as well as rise
- At the end of the term the full balance becomes due in one payment
- If the plan is to sell the property, that assumes a market and a willing buyer at a particular moment
- Lenders may require evidence of how you intend to repay, which can change during the term
The bit people miss
The quiet problem is the repayment vehicle rather than the insurance. Many interest-only mortgages were taken out alongside an endowment or an investment that was projected to clear the debt, and plenty of those have underperformed. If the plan has drifted, the shortfall exists whether or not anybody dies, and life cover does not fix it. What life cover does is stop a death turning a manageable long-term problem into an immediate one for the people left behind.
Decreasing Cover Against A Flat Debt
This is the specific mismatch worth checking on any interest-only mortgage, and it is common because of how mortgage protection is usually sold.
Decreasing term assurance is designed for repayment mortgages: the sum assured falls each year roughly in line with the outstanding balance, which is why it is cheaper. On an interest-only loan the balance does not fall. So in year one the cover matches the debt, in year ten it covers perhaps two thirds of it, and in the final years it covers a fraction while the full capital is still owed.
Level term cover costs more and is the right shape. If you hold a decreasing policy against an interest-only loan, that is worth looking at now rather than at the point somebody has to find the difference.
The Plan To Repay It Matters As Much As The Cover
Insurance deals with what happens if you die. Something else has to deal with what happens if you do not.
Interest-only mortgages are granted on the basis of a credible repayment strategy: an investment, a pension lump sum, the sale of another property, or downsizing. Those plans drift. Investments underperform, pensions get used for something else, and property markets do not always oblige at the moment you need them to.
So the useful review on an interest-only mortgage is two-sided. Check the cover is level and runs to the end of the term, and check the repayment plan is still on course. The second one is a conversation with a mortgage adviser rather than with us, and it is the one more likely to catch somebody out.
What usually fits, and why
The shape that matches the debt. The sum assured stays the same for the whole term, exactly as the capital does.
A lump sum that can clear or reduce the capital early, which is worth more on interest only than on repayment because nothing else is reducing it.
The interest still has to be paid every month, and on interest only that payment is the whole of what keeps the lender happy.
Common questions
What cover do I need for an interest-only mortgage?+
Level term life cover, matching the full balance for the full term, is usually what fits, because the capital does not reduce at any point. Decreasing term cover is the standard recommendation for repayment mortgages and is the wrong shape here, since it falls away each year underneath a debt that stays exactly the same.
I have decreasing cover on an interest-only loan. Is that a problem?+
It is a mismatch that grows every year. In the early years the cover roughly matches the debt; by the end it may cover a fraction of it while the full capital is still owed. It is worth looking at now rather than at the point somebody has to find the difference, and topping up with level cover is often simpler than replacing what you have.
Does life insurance solve an interest-only shortfall?+
No, and it is important to be clear about that. If the repayment vehicle has underperformed, the shortfall exists whether or not anybody dies, and that is a mortgage problem rather than an insurance one. What life cover does is stop a death turning a manageable long-term problem into an immediate one for the people left behind.
Would critical illness help here?+
It can be worth more on interest only than on repayment, because a lump sum paid during the term can clear or reduce capital that nothing else is reducing. On a repayment mortgage the balance is falling anyway; on interest only it is not, so money arriving early makes a lasting difference to what is owed at the end.
What if I plan to sell the house to repay it?+
That is an accepted strategy and it depends on a market and a buyer at a particular moment, which nobody controls. It is worth reviewing periodically with a mortgage adviser rather than assuming. From a protection point of view, the question is what the household would do if you were not there to manage that sale.
Cover that often goes with this
The gaps we most often find sitting next to this one.
- Mortgage life insuranceLevel and decreasing cover compared.
- When you remortgageThe natural moment to check the shape still fits.
- Critical illness coverA lump sum against capital that is not reducing.
- How much do you need?Sizing cover against the full balance.
- Talk to an adviserCheck whether your cover is level or decreasing.