Peter McGahan, Chief Executive Officer of Worldwide Financial Planning, answers the question:
A repayment mortgage is made up of interest on the loan outstanding, as well as a part of the capital being repaid over the term of the mortgage. As time goes on, the capital is decreasing, therefore the amount of interest falls, so a larger part of your monthly payment goes toward repaying the capital. Therefore, in later years, the debt falls much quicker.
An interest only mortgage has a lower monthly payment as you are only paying the interest, with the capital repaid later via an ISA, an inheritance, or even the sale of the home.
The normal, and cheapest method of insuring against a repayment mortgage would be to insure both lives for what is commonly known as a decreasing life insurance policy. As the debt falls, the amount of cover falls with it, as does the risk to the insurer. The older a person becomes, the greater the risk of death of course, but a decreasing insurance plan is insuring you for less, as that risk of death is increasing. If your budget is tight, this is the most effective way to protect you.
If you have an interest only mortgage, it is normal to insure yourself on a level term basis (the life insurance stays the same, as the debt is always the same), but if your budget was tight you could also consider a decreasing term assurance. As the ISA is increasing in value you could argue that your net debt is falling (mortgage less ISA value). Naturally, the ISA can fluctuate in value, and so it carries that element of risk that the ISA and decreasing life insurance might not be enough to repay the total loan. There could also be a surplus if the ISA had over performed.
The downside of decreasing life insurance, however, is that in later years you may well need more cover due to having a family and protecting your income, upsizing of a home and subsequently the deb, etc.
The risk is that your health has changed in between, and you may have to pay extra for your life insurance, or indeed may not be offered insurance at all.
One solution to that is to retain the level insurance as above, so your premiums are calculated on current health and remain the same for the whole term of the plan.
Another solution is to use a convertible, or renewable option on your insurance. Renewable term assurance allows you to extend the cover at the end of your plan with no evidence of your health. Therefore, if it had deteriorated, you will still be able to gain cover for the same amount and term ie you have a 15 year plan and then renew for another 15 years.
The convertible option also gives added flexibility. If you add this option at the beginning of a life insurance policy, you will be able to convert the plan to a more permanent form of life cover later, like a whole of life plan. This is done with no evidence of health or medical underwriting. A whole of life plan is as the name suggests. You pay your premiums and you are guaranteed to be insured all your life.
A whole of life plan is often used to protect against Inheritance Tax costs where the death benefit is written in trust for your beneficiaries. The benefit goes directly to the beneficiaries and not into your estate, and they then pay the tax due on your overall estate with that money.
As you can see, thinking through your life insurance as a life journey can be a very clever way to ensure you are always insurable and not lumbered with hefty premiums.
A reader gave me an example of this working recently where the insured’s plan was about to finish but they were actually dying with cancer. They remembered they had the option to renew and did so. They would otherwise have been without insurance and uninsurable at that point.
Peter McGahan is the Chief Executive Officer of Independent Financial Adviser Worldwide Financial Planning. Worldwide Financial Planning is authorised and regulated by the Financial Conduct Authority.