What it means
When you take out a loan, you promise to keep paying even if your circumstances change. A payment protection plan shifts part of that risk to an insurer.
If a covered event occurs, the insurer makes the loan repayments for a set period, or in some cases clears the balance. The plan is usually bought at the time of borrowing, often through the lender or retailer.
The cost may be added to the loan, so the borrower pays interest on the premium itself. This is one reason such plans can be expensive, and why standalone insurance sometimes gives better value.
What is covered varies a great deal. Typical triggers include accidental injury, sickness, involuntary unemployment and death.
Self-employed people, those on temporary contracts or people with pre-existing medical conditions may find that they are excluded or must meet strict conditions. Many plans also include a waiting period before payments start, and a limit on how many months of payments will be covered.
For example, cover might begin 30 days after the event and last for 12 monthly payments. Reading these terms before signing is essential, because the headline promise is often narrower than people expect.
In several countries, regulators have criticised the way these products were sold, especially where customers were pressured to buy them or were not told they were optional. As a result, many lenders now present them separately and must show the price clearly.
A sensible rule is to compare the total premium to the potential benefit and to check whether savings, sick pay or other insurance already provide cover. For a finance professional, the key points are cost versus benefit and whether the borrower has other protection.
A business that lends to customers, such as a retailer offering store credit, should understand that mis-selling can create regulatory and reputational risk.
In practice
Real-world examples.
Example
A customer buying a $3,000 sofa on store credit is offered a plan that covers the monthly instalments if she loses her job. She declines, because her employer provides generous redundancy pay and she has six months of savings.
Example
A self-employed electrician takes a $40,000 van loan and is offered a plan. After reading the terms, he finds that its unemployment cover excludes people who work for themselves, so he buys an income protection policy covering illness instead.
Example
A couple with a $250,000 mortgage buy a plan that covers their mortgage payments for up to 12 months if either of them is unable to work through illness. When one is injured in a cycling accident, the insurer pays eight payments of $1,400 while they recover.
Formula
Calculation
Total plan cost = Premium per period x Number of periods (plus interest if the premium is financed)
Break-even benefit = Total plan cost / Monthly loan payment, shown in months of payments
Suppose a borrower takes a $15,000 loan over 36 months with a monthly payment of $450, and a payment protection plan that costs $30 a month. Total cost = 30 x 36 = $1,080. Break-even = 1,080 / 450 = 2.4 months of loan payments. In other words, the plan pays for itself only if it covers more than 2.4 monthly payments (about $1,080 of repayments) during the loan, and the chance of that must be weighed against the cost.Case study
Seen in the real world.
Greenfield Home Furnishings is an illustrative, fictional retailer that offers store credit to customers. Its sales staff received a commission for each payment protection plan sold, and sales were strong.
An internal audit found that many customers did not realise the plan was optional, and that the premium was bundled into the loan, increasing the total interest they paid. The company's compliance officer estimated that the plan cost the average customer $540 over the loan term while paying out claims to very few of them.
Greenfield removed the commission, started showing the plan price as a separate line, and trained staff to explain who it suits. Sales of the plan fell, but customer complaints dropped and regulators had little to question. The illustrative lesson is that a product that is hard to justify to a customer is a business risk as well.
Watch out
Common mistakes.
- Assuming the plan is compulsory, when in most cases it is optional and the loan can be approved without it.
- Not reading the exclusions, such as pre-existing conditions or self-employment, which can leave the borrower without cover when they need it.
- Ignoring that a financed premium attracts interest, which raises the true cost above the quoted monthly fee.
Questions
People also ask.
Does a payment protection plan cover all my debts?
No. It normally covers only the specific loan or card it was sold with, and only for the events and period stated.
Is it better to buy income protection instead?
Often it can be, because income protection covers a wider range of bills and may be priced more fairly, but the right choice depends on health, job and savings.
Can I cancel the plan after buying it?
Usually yes. Most products allow cancellation, sometimes with a refund of unused premium, but the terms should be checked in the policy documents.
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