Should You Say Yes to Loan Protection Insurance?

Loan protection insurance may seem like a good way to ensure that disability or death doesn't lead to default -- but is buying this insurance smart? Find out here. Image source: Getty Images.

When you apply for a loan, including a mortgage or a personal loan, lenders may offer you loan protection insurance or credit protection insurance. These insurance policies generally promise to either pay off your loan balance in the event of your death or to make monthly payments on your debt for you in the event you become disabled or unemployed.

Buying loan protection insurance may sound like a good idea. After all, it's comforting to think that your family won't be left with a major financial burden if you should become incapable of repaying your loan.

Unfortunately, buying this type of insurance makes little sense for most people -- even though lenders may try to aggressively market this protection. Before you decide to say yes to loan protection insurance, you need to understand how it works and why other alternatives might be better.

How does loan protection insurance work?

Loan protection insurance can be purchased for almost any kind of debt, from mortgages to credit cards to personal loans. But it works differently for open-ended loans -- such as credit card debt, which has no fixed loan amount or repayment timeline -- than for closed-ended loans such as mortgages, which have a defined balance and repayment term.

• On open-ended loans, you usually pay a monthly fee for loan protection insurance, and the premium costs are determined by the amount you currently owe. The cost of loan protection insurance on these loans can fluctuate as your debt balance rises and falls.
• On closed-ended loans, the repayment amount and the terms of your loan are determined up front, so the cost of the insurance is clear from the start. With closed-ended loans, you often pay a one-time fee for the loan protection insurance at the time you take out the loan.

Whether your insurance is on an open-ended or closed-ended loan, your policy protections are activated when a covered event happens. However, many policies cap the covered loan amount or impose other restrictions, so you may not have full coverage. That's why it's important to read the fine print and figure out exactly what the insurance will pay out and when, as some policies won't pay out if you have a cosigner or if you've borrowed a large sum, and some policies have waiting periods before you're protected after buying coverage.

The specifics of what your policy covers can also vary. You could opt for involuntary unemployment coverage so that your monthly debt bills are paid if you become unemployed through no fault of your own; disability coverage so your monthly debt bills are paid if you become disabled; or credit life insurance so your debt is paid off if you die. You could also add property insurance to pay off the balance of your loan if the property you bought with the loan is destroyed or stolen.

Do you have to buy loan protection insurance?

Lenders can offer you loan protection insurance, but they cannot require you to purchase this insurance as a condition of borrowing. Lenders also can't include loan protection insurance in your loan without disclosing this to you and explaining the fees associated with your policy.

If a lender gives you the chance to buy loan protection insurance, you'll need to carefully assess whether this type of insurance is right for you.

Why buying loan protection insurance often makes no sense

Buying loan protection insurance is often a bad idea for borrowers, in large part because you're typically better off buying other insurance policies that provide more comprehensive coverage.

For example, disability insurance could give you the money you need to pay all your bills and expenses if you become unable to work due to a disability. And a term life insurance policy can provide a death benefit, the proceeds of which can be used not just to pay off one particular debt, but to provide other funds for your family as well.

Term life insurance policies and disability policies not only provide broader coverage, but they also don't have premiums that fluctuate based on how much you've borrowed on open-ended debt accounts, so your costs are more predictable. When you've paid a fixed premium for loan protection insurance on a mortgage or other closed-end loan, the value of the insurance policy goes down each year as you pay back your debt and the balance becomes smaller. This doesn't happen with a term life insurance policy, whose death benefit stays the same for as long as you're covered.

You should always compare the cost of term life or disability insurance to the cost of loan protection insurance. Unless the loan protection insurance is considerably cheaper, which it often is not, opt for the more comprehensive insurance instead.

You also need to know what will actually happen to your debt after you die. If you have a mortgage on a shared family home, that debt will need to be paid off if your family wants to keep the house. But if you have credit cards or an unsecured personal loan only in your own name, the creditors could try to collect from your estate to pay off the balance, but they couldn't come after your family and make them pay if there weren't enough money in your estate (unless someone cosigned).

Unless you're worried about your assets going to creditors in the event of your death, you may not need insurance, because creditors couldn't try to take your loved ones' money or property to recover unpaid balances due anyway.

You likely should say no to loan protection insurance

Loan protection insurance can be expensive, and it provides limited benefits in most circumstances. The only time it might make sense is if you can't qualify for a disability or term life policy and you need to make sure a debt -- such as a mortgage on a family home -- is repaid after you pass.

Outside of these limited circumstances, you should carefully consider other options and understand the downsides of loan protection insurance before you decide it makes sense to buy.