When you purchase a home, you generally take on a large financial obligation -- an obligation that is frequently secured by a non-liquid asset. If you pass on owing money on a home, your family generally cannot sell just part of the home to pay off part of the debt. It is all or nothing. Life insurance provides a cost-effective means of protecting your family from financial catastrophe and protects your creditor from the risk of having to file a lawsuit or foreclose on your home (and evict your family) to recover its costs.
Types of Life Insurance
Life insurance comes in two main varieties: term insurance, which pays a death benefit only if the insured dies within a certain period of time, or permanent insurance, which pays a death benefit no matter when the insured dies -- provided you continue to pay scheduled premiums. Permanent insurance can be whole life, universal life or variable universal life insurance. Each has advantages and disadvantages.
Using Term Insurance to Cover a Mortgage
Term insurance is a popular way of providing a means to pay off a mortgage at death. Term insurance does not build cash value. But young families can typically purchase a large amount of term insurance, more than enough to pay off a home, for very affordable premiums. You can lock in a level premium for 20 years, and some companies will even sell a 30-year-level term policy, which matches most mortgage durations. Alternatively, you can purchase a short-level term policy -- say, one to five years -- for a lower premium, and then gradually reduce your term coverage over time to manage costs, while your mortgage balance declines. If you take out a second mortgage or home equity loan, however, you may not be able to purchase insurance to cover it if you have had health problems in the meantime. You may develop a preexisting condition that would disqualify you for life insurance, or make it prohibitively expensive.
Using Whole Life Insurance to Cover a Mortgage
Whole life insurance features a guaranteed-level death benefit for life and a guaranteed-level premium for life. Over time, the policy builds cash value. The guaranteed cash value will match your guaranteed minimum death benefit, and you will get a check for your face amount if you reach the endowment age. (The endowment age was recently raised to 121, from 100, with the intention that people would not survive to collect their own life insurance.) Meanwhile, the cash value will grow at a guaranteed crediting rate, tax-free. Mutual life insurance companies additionally will pay dividends, crediting profits to your cash value. Over time, the cash value in your policy may generate enough dividends to pay policy premiums. Or your cash value may be enough for you to pay off your mortgage early.
Using Universal Life Insurance to Pay off a Mortgage
Universal life insurance features a flexible death benefit for life and a flexible premium. However, premium costs do increase as you get older. Universal policies feature a cash value account, which serves to supplement your premium payments to keep policies in force in later years. You must fund these policies aggressively to keep them in force for life, however. You can overfund these policies, subject to certain limits, to build a cash value that grows tax-free. However, if you stop making premium payments, the insurance company will debit your cash value to keep the policy in force. These policies tend to have higher premiums than term insurance, but lower premiums than whole life insurance. However, by using the tax-free buildup of the policy, you may be able to accumulate enough cash value to pay off your home early or keep the insurance in force.
Private Mortgage Insurance
Mortgage lenders require borrowers with less than 20 percent down to purchase private mortgage insurance. This protects the lender against default, but does not protect your family in the event of your death and does not accumulate cash value for you.
Mortgage Life Insurance
Mortgage life insurance is a declining death benefit policy specifically designed to match your mortgage loans amortization. The death benefit is just enough to pay off the mortgage balance. This coverage does not take into account the other hardships that your death may cause, such as the loss of income, final medical expenses and funeral costs.