Residual loan insurance secures the lender against missed loan payments. Unforeseen events such as the death of the borrower (death) or illness and incapacity for work can thus be covered, ensuring the outstanding loan amount is protected.
Lenders often require this as loan collateral and expect the borrower to assign the insurance to the bank. In most cases a bank will insist on this credit insurance, because otherwise it may not grant the loan.
Procedures and Forms of Residual Loan Insurance
When a customer goes to a bank to request a loan, they often take out residual debt insurance along with the loan. In any case, the borrower bears the costs of taking out this residual debt insurance. This residual debt insurance is coverage against death, occupational disability or incapacity for work, unemployment or short-time work during the entire loan term. That means that if the borrower dies, any remaining outstanding debt (i.e., remaining loan installments) under the loan agreement is paid off by the insurer for the insured, or in the event of illness or unemployment the insurer continues to pay the loan installments. The bank (the loan provider) will ask its customers to join a group insurance contract that the bank has taken out, which means that the customer's or borrower's conclusion of this contract is not subject to the same formal requirements under insurance law as an individual insurance contract.
Looking at residual loan insurance, it has proven successful since 1950—when the first insurance of this type was approved by the Federal Supervisory Office for Insurance—as protection for installment loans or annuity loans. This insurance was concluded by paying a one-time premium, which was co-financed in the loan. In the case of overdraft or revolving credit, the outstanding balance is calculated each month and the premium for that month is recalculated.
With annuity loans, the repayment installment of the loan remains the same during a fixed interest period. The installment contains interest and principal portions, and at the end of the term the loan is fully repaid. Revolving credit is kept in an account that is always in the red, as with a credit card account. It becomes immediately clear that the interest rates are significantly higher than for standard loans. Often, so-called small loans are financed over a short period in this way.
One option for residual debt insurance is to take out a term life insurance policy with a decreasing sum insured. It usually provides sufficient coverage to secure, for example, mortgage loans. This variant is relatively inexpensive and often includes the provision that premium payments can be suspended in the event of unemployment. Additional forms of residual debt insurance since 1995 include insurance against involuntary unemployment and, since 2006, insurance against illnesses such as heart disease, cancer, stroke and insurances for so-called assistance services like support for reintegration into working life.
How Does Residual Loan Insurance Work?
An insurance policy is taken out at the time the loan is taken out that corresponds to the loan term. Many insurance companies limit the term to a maximum of 10 years. The insurance charges a one-time premium, which the borrower can co-finance with the loan amount. An annual payment option is also possible, which continues throughout the loan term.
A convenient aspect of this insurance is that a health check is usually not required. Only an exclusion clause is typically agreed, which, for example, excludes certain illnesses from coverage. With the signature, the insurance takes effect immediately. However, insurance companies also tend to impose a three-month waiting period for the unemployment add-on coverage.
Advantages of Residual Loan Insurance
What benefits does residual debt insurance provide? For one, the lack of a required health check simplifies the contract conclusion considerably. This insurance offers a private-law protection against involuntary unemployment.
Disadvantages of Residual Loan Insurance
A disadvantage can arise if there are pre-existing conditions at the time the insurance is taken out. These are excluded from benefits for the first two years of the residual loan insurance. That means a restriction of the insurance benefit to illnesses that are not causally related. Due to contractually agreed exclusion periods for certain insurance benefits, the insurance only takes effect after these exclusion periods expire; a so-called waiting period is agreed. Or the claim event must already have lasted a minimum time, for example in the case of unemployment, short-time work or incapacity for work, before the residual debt insurance comes into effect. Cancelling a residual debt insurance can also be problematic, especially when it is tied to the loan agreement. Here the borrower usually has almost only the option to refinance the loan, which incurs a prepayment penalty. Only when the loan is fully repaid is cancellation of a residual loan insurance straightforward.
Refinancing is only advisable if the interest offer for refinancing is significantly more favorable. A final argument against residual debt insurance seems to be the relatively high commissions for mediation to the lender. These high total costs have a lasting influence on taking out the loan. Under German law, residual debt insurance must be included in the effective interest rate. However, residual debt insurances are not mandatory; they are nevertheless often offered by lenders and sometimes required as a condition for granting the loan, whereby they earn the commissions through additional coverage contributions.
The Dream of Homeownership Can Become Reality
Even when the loan and insurance are sold as a package, they are still two separate contracts. According to the Bundesanstalt für Finanzdienstleistungsaufsicht the bank should give the customer the free choice to take out this residual debt insurance. The costs for such insurance do not necessarily have to be included in the annual percentage rate. There are various calculation examples showing that if this insurance were included in the APR, the insurance could easily double what would otherwise be a 7.56% annual rate.
Residual loan insurance is not mandatory, but most banks require it from the borrower/insured as security. It is unnecessary if there is already a life insurance policy that can be used as security for the loan and is the recommended option. Only for mortgage financing is it advisable to also consider family members. Here the surviving dependents should be secured in the event of death, which is especially worthwhile if loan installments are carried by only one partner. In the event of death, the residual loan insurance then comes into effect.
Because it typically takes about 20 years for a construction loan to be fully repaid, this can mean financial ruin for a family if adequate protection was not considered. It is advisable to obtain quotes from different providers before taking out residual loan insurance to avoid ultimately paying excessively high installments. Loans always carry risk. To make the dream of homeownership come true, comparing offers is sensible and always worthwhile.