For banks and financial institutions, lending always involves a certain risk. In order for borrowers to take out a loan, it is often necessary to secure the loan. In this way, financial institutions increase their own security and minimize the risk of default.
This is a credit protection
Credit protection is a financial instrument. In financial accounting, it is used to secure a loan that has been granted. Banks minimise the risk of the borrower defaulting. This financial instrument is used in all areas of finance where creditor/debtor relationships are commonplace.
The reasons for credit protection
From the point of view of both the lender and the borrower, it makes sense to secure the loan. In this way, the financial institution wants to increase the probability that it will recover the borrowed money. If the borrower unexpectedly gets into payment difficulties and is unable to repay the loan, credit protection steps in. In this way, the loan can be balanced, for example, through a garnishment.
However, from the point of view of the borrower, such a security also seems to make sense. Through this procedure the borrower protects his family and relatives. In the event of disability or death, the relatives would otherwise face financial burdens, often considerable ones. By means of the security, the bank can realise the collateral. There is therefore no recourse to the surviving dependents or relatives.
In these cases it is worthwhile to take out credit protection
Credit protection is particularly recommended for loans with long maturities. After all, it is hard to predict how life will develop over the next ten years or more. Moreover, even if your credit rating is poor, hedging is preferable. There are the following reasons, for example:
- negative Experian contribution
- many more credits
- little income
- senior borrower
However, a regular salary is often sufficient, especially for small loan amounts. As a guideline, it is advisable to rely on credit protection for loans of 25,000 GBP and more at the latest.
Options for credit protection
There are numerous options for credit protection. In practice, the following variants are particularly popular:
- Residual debt insurance
- second borrower
- Term life insurance
- Occupational disability insurance
Residual debt insurance
Residual debt insurance is an additional financial product that banks offer together with a loan. Residual debt insurance is linked to a specific loan. A transfer to other loans is not possible. If the borrower becomes unemployed or disabled, the residual debt insurance covers the borrower. In this case, the insurance pays the outstanding amount to the bank. In principle, the idea is understandable and tempting for many consumers. Nevertheless, this financial product has been criticised by consumer protection agencies for several years. In particular, the following aspects are being critically considered:
- no standardised insurance coverage
- widely differing policy conditions
- Comparatively expensive type of hedging
- Suggesting residual debt insurance as a necessity
Tip: Borrowers should check the insurance conditions carefully. Especially with low loan amounts, residual debt insurance is a comparatively expensive way of securing credit.
It is also possible to secure a loan with the help of a guarantor. The guarantor then pays further installments to the bank in case of the borrower’s default. To secure the loan, the guarantor and the bank conclude another agreement – the so-called guarantee agreement. This distinguishes the guarantor from the second borrower. Nevertheless, guarantees rarely occur in practice. Many banks do not offer such a possibility.
As already indicated, credit protection is also provided with a second borrower. This borrower takes up the bank loan together with the other borrower and signs the loan agreement. This type of credit protection is particularly useful in cases where both borrowers benefit from the money borrowed. For example, in the case of a construction loan, it is advisable for a married couple to take out a loan together. However, the success of the hedging is subject to the condition that the second borrower has a good credit rating. In such cases, the bank often agrees to a loan, even if the first borrower would not be granted a loan on his own.
Term life insurance
Term life insurance is particularly suitable as credit protection for the family. In the event of death, the life insurance policy steps in and pays out the insured sum in full. The surviving dependants can then pay off the loan and are free of debt. Term life insurance thus offers comprehensive protection against debt on the part of surviving dependants. Since repayment over the years leads to a decreasing credit sum, overinsurance is likely.
Occupational disability insurance
Occupational disability insurance is another possibility for securing the loan. In the event of occupational disability there is a risk of non-payment. Borrowers no longer receive their monthly salary and cannot repay the loan. In this case the occupational disability insurance pays a monthly pension. Policyholders can contractually determine the amount of this pension. In the event of a serious illness there is thus financial security. Thus, the occupational disability insurance does not directly secure the loan. Rather, the occupational disability insurance can minimise a certain risk – the inability to pay due to occupational disability in the event of illness or accident.
Mortgages are used in particular to finance a property as loan collateral. The bank receives the rights to the property. In the event of payment difficulties or default, the bank can sell the property to balance the loan. Without the bank’s consent, the real estate owner cannot sell the property. In contrast, however, the use of the apartment or house is unrestricted.
In most cases, borrowers use the equity to reduce the loan amount already. After all, a large loan is often not even necessary. However, the use of equity capital is not always recommended. Especially when equity capital is invested profitably, consumers can take out a loan and secure it with equity capital.
Advantages and disadvantages of credit protection
The instrument of credit protection is exclusively beneficial to the financial institution in particular. But even such an approach offers both advantages and disadvantages:
These are the advantages
- Continued payment of the loan is secured
- Protection of heirs and relatives
- Hedges such as term life or occupational disability insurance offer high added value
- good chances of getting a loan
These are the drawbacks
- high costs for the protection
- non-transparent products
Credit protection costs
The cost of credit protection depends on the preferred option. In addition, other factors play a considerable role, so that general statements are not possible. Credit protection is generally relatively expensive and increases the cost of a loan considerably. In contrast, however, some types of protection such as insurance services offer further added value and numerous advantages.
Conclusion – Is it worthwhile securing the loan?
Hedging is particularly recommended for large loans. Otherwise, high risks for family and relatives are imminent. The best way to secure a loan depends on the personal situation and the specific loan. Furthermore, the purpose of the protection is decisive. If borrowers primarily want to protect their family from financial burdens, term life insurance is a good option. On the other hand, a mortgage is recommended when buying a property, while for loans in the low range, the second borrower in particular is a good option for security.