For banks and financial institutions, lending always poses a certain risk. In order for borrowers to take out a loan, it is often necessary to secure the loan. The financial institutions thus increase their own security and minimize the risk of default.
A credit request on Fine Bank has no effect on your personal Credit Bureau score.
This is a credit protection
Credit protection is a financial instrument. In finance, this serves to secure a loan. Banks minimize the risk of the borrower defaulting. This financial instrument comes in all areas of finance, in which relationships between creditor and debtor are the order of the day. in front.
The reasons for credit protection
From the perspective of both the lender and the borrower, securing the loan makes sense. In this way, the financial institution wants to increase the likelihood that it will get the borrowed money back. If the borrower unexpectedly gets into payment difficulties and is unable to repay the loan, the credit protection takes over. This makes it possible to compensate the loan, for example through a garnishment.
But from the borrower’s point of view, such protection seems to make sense. By doing this, the borrower protects his family and loved ones. In the event of disability or death, relatives are otherwise faced with financial burdens that are often considerable. The bank can exploit the security by hedging. There is therefore no recourse to surviving dependents or relatives.
In these cases, credit protection is worthwhile
A credit protection is particularly recommended for loans with long terms. After all, it is difficult to predict how life will develop over the next ten years or more. In addition, hedging is preferred even if the creditworthiness is poor. The reasons for this are, for example:
- negative Credit Bureau contribution
- many more loans
- low income
- Borrowers at an advanced age
However, a regular salary is often sufficient, especially for small loan amounts. As a guideline, we recommend using credit protection at the latest for loans of USD 25,000 or more.
Credit protection opportunities
There are numerous options for credit protection. In practice, the following variants are particularly popular:
- Payment protection insurance
- second borrower
- Term life insurance
- Disability insurance
Payment protection insurance
Residual debt insurance is a financial additional product that banks offer together with a loan. The 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 will step in for the borrower. In this case, the insurance company pays the outstanding amount to the bank. Basically, the idea is understandable and tempting for many consumers. Nonetheless, this financial product has been criticized by consumer advocates for several years. The following aspects in particular are critically considered:
- no standardized insurance benefits
- very different insurance conditions
- comparatively expensive type of protection
- Suggestion of residual debt insurance as a necessity
Tip: Borrowers should carefully review the insurance terms. With low loan amounts in particular, residual debt insurance is a comparatively expensive way of securing credit.
A loan can also be secured with a guarantor. The guarantor then pays the further installments to the bank if the borrower fails. The guarantor and bank concludes another contract to secure credit – the so-called guarantee contract. This differentiates the guarantor from the second borrower. Nevertheless, guarantees are rare in practice. Many banks do not offer this option.
As already indicated, credit is also secured with a second borrower. The latter takes out 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 raised. For example, in the case of construction finance, borrowing from a couple is a good option. However, the success of the hedge is based on the premise that the second borrower has a good credit rating. In such cases, the bank often approves a loan, even if the first borrower alone would not be granted a loan.
Term life insurance
A risk life insurance is particularly suitable for credit protection to secure the family. Life insurance steps in in the event of death and pays the sum insured in full. The survivors can then pay the loan and are debt free. The risk life insurance thus offers comprehensive protection against the indebtedness of the bereaved. As repayment leads to a decrease in the loan amount over the years, overinsurance is likely.
Another option for securing the loan is occupational disability insurance. In the event of an occupational disability, there is a risk of default. Borrowers no longer receive the 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 financial security. The occupational disability insurance does not directly cover the loan. Rather, occupational disability insurance can minimize a certain risk – inability to pay due to disability in the event of illness or accident.
Mortgages act in particular when financing a property to secure credit. The bank gets the rights to the property. In the event of payment difficulties or a default, the bank can sell the property in order to settle the loan. The property owners cannot sell the property without the bank’s consent. In contrast, the use of an apartment or house is unrestricted.
In most cases, borrowers use equity to reduce the loan amount. After all, a high credit is often not necessary. However, the use of equity capital is not always recommended. Especially in the case of profitable investments in equity, consumers can take out a loan and secure it with equity.
Advantages and disadvantages of credit protection
The credit protection instrument is particularly advantageous for the financial institution. But such an approach also has both advantages and disadvantages:
These are the advantages
- Continued payment of the loan is secured
- Protection of heirs and relatives
- Insurance such as life insurance or disability insurance offer great added value
- good chances of getting a loan
These are the disadvantages
- high protection costs
- non-transparent products
Credit protection costs
The cost of credit protection depends on the preferred option. In addition, other factors play a significant 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 insurance such as insurance benefits offer further added value and numerous advantages.
Conclusion – is it worth securing the loan?
Protection is particularly recommended for large loans. Otherwise there is a high risk for family and relatives. The best way to secure credit depends on the personal situation and the specific loan. In addition, the purpose of the hedge is critical. If borrowers primarily want to protect their family from financial burdens, life insurance is a good option. In contrast, a mortgage is recommended when buying a property, while in the case of loans in the low range, the second borrower in particular can be used as a protection.