Using Life Insurance to Pay Off Debt
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Paying down debt can be financially draining and stressful and not something you'd want your loved ones to take on after you die. The good news is that debts are rarely inherited, so most likely, the people you care about won't be left holding the bill. However, there are instances when an outstanding balance can become the responsibility of others. In situations like this, you can get a life insurance policy to cover the amount you owe, and the payout can help your beneficiaries pay it off.
According to a new NerdWallet study, 35% of Americans who buy life insurance do so to cover significant debts that others would be responsible for. Learn more about how debt gets passed down and what type of debt you may want to cover.
The primary purpose of life insurance is to replace your income after you die. So, aside from covering debt, you may need coverage if anyone relies on you financially. The payout can replace your salary and give your loved ones the cash they need to maintain their lifestyle.
What happens to your debts after you die?
In general, the assets in your estate are used to pay off your debts when you die. If there's not enough money in the estate to settle the debt, it goes unpaid. However, there are circumstances where other people may be responsible for the remaining balance.
Cosigners and joint owners: If someone cosigns your debt, they're typically responsible for it after you die. Similarly, a joint owner of the debt is equally accountable for it. So if you or the joint owner die, the surviving member must pay off the balance.
Spouses: In community property states, surviving spouses are responsible for debts left by deceased partners. Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin are community property states. Alaska, South Dakota and Tennessee have elective community property rules. In some states, spouses may be responsible for certain debts like health care.
Even if no one is responsible for your debts after you die, you may still want coverage. A life insurance payout can help your beneficiaries pay off the debt so the money in your estate can go to your heirs. You can also use life insurance to leave a separate inheritance from your estate.
If you'd be responsible for someone else's debt if they died, you can buy life insurance on their life with their consent and put yourself as the beneficiary.
Covering debt: Term or permanent life insurance?
Term life insurance is sufficient for most families and a common option for covering debt. These policies are designed to last for a set period, like 10 or 20 years. You can choose a term length that matches the length of the loan. For example, if you have a 20-year mortgage, you can buy a 20-year term life policy.
The other type of life insurance is called permanent life insurance. Unlike term life, these policies are open-ended and designed to last your entire life, though some policies have a maximum payout age of 90 to 120 years old — so be sure to look at the fine print. Generally, though, if you want your beneficiaries to receive the death benefit regardless of when you die, a permanent policy like whole life insurance may be a good fit. However, permanent policies are more expensive than term life policies and you may not need lifelong coverage.
» MORE: Average life insurance rates
What type of debt does life insurance cover?
Beneficiaries can spend a life insurance death benefit as they see fit, so it can be used to pay off any debt. Mortgages, credit card bills and personal loans are a few examples of debts that a policy can help settle after you're gone.
Using life insurance to pay off a mortgage
If someone cosigned your mortgage or is a co-borrower on the loan, they'd be responsible for the debt if you die. Putting them as the beneficiary on a life insurance policy means they can use the payout to settle the debt and keep the house.
If no one is responsible for the debt and your estate doesn't have enough funds to cover the mortgage, the lender may foreclose on the property. However, if someone inherits the home and wants to keep it, they're typically allowed to keep paying the mortgage. If this happens, a life insurance payout can help them cover the cost. So even if your heirs are not legally responsible for the mortgage after you die, they may still benefit from a life insurance payout.
Mortgage protection insurance vs. term life insurance
Mortgage protection insurance is optional coverage lenders offer when you purchase a home. These policies pay off your mortgage if you die with a balance. The death benefit declines over time to match the outstanding sum you owe on your mortgage. For example, your lender might issue a $500,000 policy to cover your $500,000 mortgage. As you make payments, your life insurance face amount will decrease. The payout goes to the lender, not to your family.
Term life insurance is often cheaper than mortgage protection insurance and provides the same coverage with greater flexibility. The payout from a term life policy goes to your life insurance beneficiary and can be used for any purpose.
Using life insurance to pay off student loans
Student debt is often forgiven after death, so life insurance coverage may not be necessary.
For example, if you take out a parent's federal PLUS loan for your child's college fees, and you or your child die, the debt is discharged.
Even if you cosign a private student loan, you may not be responsible for the debt if your child (the borrower) dies. This is because private student loans taken out after 2018 must adhere to the Economic Growth, Regulatory Relief, and Consumer Protection Act, which requires lenders to release cosigners from any obligation to pay off the debt if the borrower dies.
However, if your child relies on your income to pay off their student loan and you die, a life insurance payout can help them cover the debt in your absence. You may also consider getting a life insurance policy if you take out a private parent loan for your child. These loans are usually not discharged if you (the borrower) die, which means the debt will likely become part of your estate. The payout from a life insurance policy can be used to pay off the debt instead of your assets.
Using life insurance to pay off credit card debt
The remaining balance on your credit cards may become the responsibility of a cosigner or joint owner of your account. Buying a policy to cover the amount you owe can help your beneficiaries pay it off if you die. Authorized users, such as partners or children who are allowed to use cards on the account, are not responsible for the debt.
Credit life insurance vs. term life insurance
Credit life insurance is a type of coverage offered by lenders, but it isn't always the best or cheapest option. The death benefit in these policies decreases as the loan gets paid down, but your insurance premiums stay the same. Plus, the death benefit goes to the lender to settle the debt, not to your beneficiaries.
To compare, term life pays out to your beneficiaries, not the lender. And the death benefit typically doesn't decrease as the loan gets paid down, so your beneficiaries receive the full amount if you die within the policy's term.
Using life insurance to pay off business loans
After you die, the payout from a life insurance policy can help your business partners pay off any loans they'd now be solely responsible for. Even if your partners are not required to pay off the loan, a life insurance payout can help cover costs during a difficult time.
Life insurance can also fund a buy-sell agreement, which allows partners to buy out the deceased partner's stake in the company.
How much life insurance do you need to cover your debt?
Use our debt calculator to estimate how much life insurance you need.
If you have debt that generates interest, like a credit card, don't forget to factor in the added amount when calculating your coverage.
Covering large debts isn’t the only purpose for getting a policy. Here are other common reasons to buy life insurance.