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Product 411: Loan Protection Pros and Cons

When taking out a loan or getting a new credit card, you may be offered loan protection (insurance). What is it, how does it work and are there any downsides? Let’s take a closer look.
10-2 Loan Protection
Image by Oleksandr Pidvalnyi from Pixabay

What is Loan Protection?

Loan protection is a form of insurance. For a fee, the insurance will cover monthly payments, or a portion or all of the payment in the event of death, job loss or disability. Each policy is unique to the insurer so be sure to read and understand the contract carefully.

How Does Loan Protection Work?

Insurance involves the underwriter, the life/item insured, the policy holder and the beneficiary. Sometimes there is overlap; the policy holder can be the life insured but the policy holder can also have someone elses life insured.

Using the example of loan protection, in this case:

  • Underwriter: the institution making the payments if the insurance payout comes into play.
  • The life/item insured: the person whose death or disability triggers the payout and/or their mortgage, credit card, line of credit, etc.
  • Policy holder: the person that signs the policy in agreement with its terms and pays for the policy.
  • Beneficiary: the recipient(s) of the benefit, or payout.

Are There Any Downsides? What are the Pros and Cons?

There are many benefits to loan protection:

  • Peace of mind
  • Preservation of credit score
  • Having payments made in the event of death, disability or job loss

However, if the loan is for a relatively small amount, such as a credit card with a low limit, you maybe be better off having emergency funds rather than paying a monthly fee. The smaller the loan, the less you need to protect it.

Big loans (car, mortgage, etc.) should be protected – but look at all your options. Bank-provided mortgage protection protects the bank and pays out to the institution, not your beneficiaries. It is also generally not portable; if you switch banks between terms, you could lose the protection and have to set it up again with your newest lender. The payment also does not decrease with your mortgage; you pay more for less as you pay off the mortgage.

Some use life insurance or disability insurance as an alternative to bank-provided mortgage insurance. This strategy pays the family or the life insured and is much more flexible. The downside here, however, is that the person receiving the payout must be financially literate and trustworthy. If the money is to pay back a loan, there is nothing from stopping the beneficiary from using the money for other things. Also, disability insurance has a very rigid structure and low limits for some professions. It typically pays out monthly instead of a lump sum.

Always Get Advice for Your Situation

As with most financial products, there is no one-size-fits all solution. The loan protection you need should match your unique situation and long-term goals. Consult with a financial planner or insurance broker to find the best loan and loan protection for your needs.

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