Buying life insurance to cover your home loan is a good idea. For both borrowers and the banks.
I recently came across a home loan product from Bank of Baroda, where the bank charges you a higher rate of interest if you don’t purchase a loan (credit) insurance product from the bank. This is a nice thought. Left to themselves, most borrowers wouldn’t buy life insurance to cover their loan. Hence, the bank has structured the loan in a manner that nudges borrowers to buy a loan insurance product. Many borrowers may buy the product simply to get a lower rate of interest.
But, do you really save much by buying the loan insurance product from the bank? For the Bank of Baroda product, if you buy credit insurance through the bank, you will get a discount of 0.05% on the loan interest rate. How much difference will this make? Let us consider an example.
Loan: Rs 50 lacs, Loan Tenure = 20 years, Interest Rate: 9% p.a.
EMI shall be Rs 44,986
If you do not buy the credit insurance product from the bank, you will have to pay 0.05% extra i.e., the interest rate will go up to 9.05%.
Let’s say, you choose not to buy the bank’s credit insurance product. Your EMI increases to Rs 45,147. An increase of Rs 161 per month.
Over 20 years, that amounts to 161 X 240 = Rs 38,618. Less than 1 EMI.
And if you choose to prepay the home loan aggressively as many borrowers do, this difference will only come down.
Hence, if you skip the credit insurance product and agree to pay a higher interest rate, it does not make a huge difference. You do not really pay much extra. For many borrowers, this may not be an amount worth bothering about.
But Aren’t We Missing a Point?
You clearly need life insurance to cover the home loan amount. You don’t want your family to struggle to repay the home loan after you and live under constant threat of losing your dream house.
There are only two reasons why you may choose not to buy life insurance to cover your home loan amount.
- You already have sufficient life insurance, enough to cover all your goals and the outstanding loans. In that case, buying an additional life insurance product does not add any value.
- You have enough assets that can be disposed off to square off the home loan. Or enough income avenues for the family to regularly repay the home loan. And such a sale of assets does not compromise other financial goals of the family.
If the above 2 factors don’t apply, then you must buy life insurance to cover your home loan.
Assuming you do not have life insurance to cover your home loan, you have 2 choices.
- Buy loan insurance from the bank. Save 0.05% interest on the home loan. OR
- Buy term life insurance directly from an insurer. Pay 0.05% extra on the home loan.
The Bank of Baroda website does not give details about the credit (loan) insurance product and its cost. Hence, it is difficult for me to compare the two options.
However, we do know the cost of buying term insurance directly. Also, we know how much extra you will have to pay if you choose NOT to buy credit insurance product from the bank. With this information at hand, we can decide which is better of the 2 options available.
Which Is a Better Option?
A few more assumptions.
Term insurance plans are level cover plans i.e., the coverage remains constant throughout the plan tenure.
Credit Insurance (or Loan Insurance or Home Loan Protection Plans) come in two variants. Reducing cover and Level Cover. Under the reducing cover plans, the life insurance cover reduces as the loan gets repaid (as per the original amortization schedule). We have seen in a previous post how reducing cover plans can fail to achieve your purpose. Hence, let’s assume that the bank is selling you a level cover plan.
We further assume that you won’t prepay the loan. And the interest rate will remain constant during the entire tenure. The borrower’s age is 35 years.
By not buying insurance from the bank, we know that you will pay Rs 161 per month extra for 20 years.
Further, you will have to pay for term insurance (50 lacs for 20 years. For a 35-year-old). I checked the quotes for such term insurance policy on a leading web aggregator. The premiums ranged from 7,000 to 10,000 per annum. I will assume the cost of such a plan at 8,500 per annum.
Hence, if we look at the total cost over 20 years, you pay a total of Rs 161 X 12 X 20 + Rs 8500 X 20 = Rs 2,08,064 over 20 years
That’s approximately Rs 10,500 per annum.
Now, we don’t know the cost of the credit plan from Bank of Baroda. But we know the threshold.
If the credit insurance sold by the bank costs more than Rs 10,500 per annum, then it is better to buy the plan on your own.
I believe that the insurance product from the bank will be more expensive. Additionally, since the banks will try to push single premium product here, the bank will also offer you loan to purchase insurance. Hence, you must account for the interest on that loan too.
As I have always said, a bit of math does no harm.
In the above example, I have merely focused on the cost aspect. A separate life insurance plan will be much more flexible. If you close the loan sooner (and you do not need this life cover), you can simply stop paying the premium and the plan will automatically lapse. On the other hand, in the loan insurance product sold by the bank, you will have to check the surrender conditions and check how much you will get back. You will encounter this issue if you have opted for a single premium plan. In addition, if you have taken a loan to pay the insurance premium, you will have to close that loan separately. A bit messy, isn’t it?
Simple is usually better.