How does loan protection insurance work?

Loan protection insurance is a policy that pays your credit card balances and loans if you become unemployed, are disabled or die. According to the Federal Trade Commission (FTC), there are four main types of loan protection insurance:

  • Credit life insurance pays off all or some of your loan if you die. Mortgage protection insurance is a common example.
  • Credit disability insurance makes loan payments if you can't work because you're ill or injured.
  • Involuntary unemployment insurance pays on your loan if you lose your job and it's not your fault.
  • Credit property insurance offers protection if personal property that is used to secure a loan is destroyed in an accident, theft or natural disaster.

While these are typically lumped together, there are differences. Credit insurance products, such as mortgage protection insurance, are regulated by the state, while debt protection products, such as those for credit cards, fall under the jurisdiction of the Consumer Financial Protection Bureau.

While a lender may recommend or even pressure you to purchase credit protection, per the FTC it's illegal for a lender to include the insurance without your permission.

Do you need loan protection insurance?

If you're in a tight financial situation and are afraid of what might happen if you weren't able to make payments due to a disability or job loss, or worse, if you were to die, loan protection insurance can seem like a good safety net. 

It's certainly a good idea to plan for the unexpected, but it's important to remember that loan protection insurance is very limited. It usually only pays specific bills, and won't help you with things like groceries and utilities. Make sure you investigate other options for protecting your family financially, including disability insurance, accident insurance and life insurance. They may provide a broader financial safety net.

What does mortgage protection insurance cover?

Mortgage protection insurance is one of the most common types of loan protection insurance. When you take out a mortgage, you're likely to receive offers of mortgage protection insurance. The offers may come from your lender or from independent insurance companies.

Mortgage protection insurance pays the death benefit directly to the lender to pay off your mortgage. That differs from traditional life insurance, which makes payment to a beneficiary you have named.

Mortgage protection insurance is different from private mortgage insurance (PMI), which you may be required to buy as a condition of your loan if you put less than 20 percent down on a house. PMI doesn’t pay off the mortgage; it pays the lender if you fail to make your payments.

Some mortgage protection insurance benefits gradually decrease over time, tied to the declining balance of your mortgage.

You also may see your premiums change over time. So you run the risk of premiums increasing and the payout decreasing.

You also may be offered mortgage disability insurance or mortgage unemployment insurance to cover your payments because of disability or job loss. The money will be paid directly to your lender. With traditional disability insurance, you receive compensation if you're unable to work for a certain period of time.

You may be offered similar types of life, disability and unemployment coverage if you take out an auto loan, open credit cards, or take out a personal loan.

Should you buy life insurance instead of loan protection insurance?

If you're worried about leaving your loved ones with debts to pay if you die, life insurance is likely a better choice.

Even the FTC cautions it may be cheaper to purchase life insurance than credit insurance. Life insurance is usually more affordable and offers a more flexible death benefit. It can even include living benefits that pay out while you are still alive.

Consider a term life insurance policy, which covers you for a certain length of time, such as 20 or 30 years. If you die after 10 years, your beneficiaries would receive the face value of your policy when you die and not pay taxes on it. If you died after 35 years, they'd receive nothing.

Life insurance premiums are typically cheaper if you buy a policy when you're younger.

If you're older or in poor health, you might consider guaranteed or simplified-issue life insurance. Policies are generally offered for small amounts, such as $10,000 or $20,000.

If you worry about making your payments if you're disabled, you can purchase short- and long-term disability insurance.

Questions to ask before you buy loan protection insurance

If you're still interested in credit insurance and debt protection products, the FTC has a list of questions you should consider.

  • How much is the premium?
  • Will the premium be financed as part of the loan? If so, it will increase your loan amount and you'll pay additional interest.
  • Can you pay monthly instead of financing the entire premium as part of your loan?
  • How much lower would your monthly loan payment be without credit insurance?
  • Will the insurance cover the full length of your loan and the full loan amount?
  • What are the limits and exclusions on payment of benefits, or what exactly is covered and not covered?
  • Is there a waiting period before coverage becomes effective?
  • If you have a co-borrower, what coverage does he or she have and at what cost?
  • Can you cancel the insurance? If so, what kind of refund is available?