Are there people counting on you for income? If you died tomorrow, are there people — like your parents — who would be stuck with the funeral costs? Do you have a plan in place to make sure you don’t wreck your loved ones’ finances?
While a 2016 LIMRA report shows that 70 percent of U.S. households have some sort of life insurance, the same report says almost half don’t have enough life insurance to cover their needs.
But it’s not just about making sure you have life insurance. Getting the right type of life insurance matters — and can mean a difference of thousands of dollars over your lifetime.
There are two main types of life insurance: term (which expires) and whole life (which doesn’t). Depending on your situation, one may work better for you than another.
Whether you need your first life insurance policy or you’re looking to boost your coverage to meet your needs, here’s what you need to know about choosing term versus whole life insurance.
Term life insurance
Term life insurance is temporary coverage. You choose a term length from your insurance agent or broker. There are different categories of term life insurance:
- Level term: Your premium and death benefit are the same for the whole term you choose. Insurance companies offer terms of between five and 40 years.
- Renewable term: Your death benefit stays the same, but the contract can be renewed on a regular basis. You might see a premium increase with each renewal.
- Decreasing term: The premium remains the same, but the death benefit decreases. When the death benefit reaches zero, the policy ends.
- Return of premium: Some insurers now offer “return of premium” term life insurance policies. If you don’t renew at the end of the term, you receive some or all of what you paid in, depending on the policy. These types of policies generally come with higher rates, though.
With term life insurance, the policy ends at some point. If you don’t die by the end of the term and you don’t renew the contract, your death benefit expires.
Advantages of term life insurance
The biggest advantage of term life versus whole life insurance is the low cost. Because the term is limited and you don’t build cash value, insurance companies offer it at a lower price.
Life insurance premiums are based on gender, health, location, term length, and other factors. The younger and healthier you are, the lower your insurance premiums.
I bought a 30-year term life policy 12 years ago, and my premium is $17 per month for $300,000 in coverage. I also have a whole life policy, bought 15 years ago, with $50,000 in coverage. The premium is $36 per month. That is a little more than twice as high for the term life coverage, even though the death benefit is much smaller.
Another advantage of term life insurance is the flexibility in choosing the length of the policy. I chose a 30-year term because I wanted to make sure my son grew up and had a good start in life, even if I died.
My term life policy will expire in 18 years. If I die before then, the death benefit is enough to cover my son’s living expenses and college costs. This is especially true since the insurance payout is combined with my retirement accounts and his 529 plan.
However, you might have different needs. A 20-year term could be enough for you, or maybe you want a bigger death benefit. I have no mortgage, relatively little consumer debt, and my student loan balances will die with me. My death benefit might be seen as small to some, but it’s adequate for my family’s situation.
Only you know your situation, so it’s important to evaluate your needs when choosing life insurance coverage.
Disadvantages of term life insurance
With term life insurance, all the premiums you pay go toward keeping the policy active. You don’t build cash value and there’s no chance at earning dividends. Once the policy expires, the premiums you have paid are gone, with no benefit remaining (unless you pay for “return of premium” life insurance).
On top of that, renewing a term life insurance policy when it expires can mean a higher premium. If you reach the end of a 30-year term and decide you want to extend it, you might have to go through another health exam and could even be denied coverage.
I’ll be 55 when my term life insurance policy expires, so I used insurance broker Chris Huntley’s life insurance cost calculator to see how much a 55-year-old female in good health would pay for $300,000 in coverage, for both term and whole life policies.
There’s a huge jump to almost $96 per month on a new term life insurance policy. If I decide I want to renew my contract, I might not be able to afford the term life premium — and the whole life premium would be entirely out of my reach by that point.
Who is term life insurance best for?
Term life insurance is best for those who can’t afford high premiums. If you want to protect your family but can’t afford the higher whole life premiums, term life can make sense. For families with children, consider buying a life insurance policy with a term that will at least see your children to adulthood if you die.
Term life insurance can also make sense if you think you can do better by investing the difference in cost between a term life policy and a whole life policy. Huntley’s calculator offers this assessment for a 25-year-old buying $500,000 in life insurance coverage:
In this scenario, your annual premium with term life is $240 and your annual whole life premium is $3,966. Investing the difference of $3,726 each year for 30 years, assuming a somewhat generous 7.5 percent return, results in $385,277. That could provide a substantial boost to your retirement account.
However, be careful if you take this approach. A 2015 study published in the Journal of Financial Service Professionals found that this strategy is unrealistic for some consumers. Financial discipline and the means to invest the difference in premiums are needed, so make sure you are prepared for this tactic before you decide to buy term life insurance and invest the difference.
By integrating term life insurance into a long-term financial plan with the help of a professional, it’s possible to both provide for your family’s needs in case of an untimely death and prepare for the future in case you live to your golden years.
When your term expires, if you have saved for retirement and college costs along the way, you probably won’t need to renew your term life insurance policy.
Whole life insurance
Now let’s look at your other option. Whole life insurance (some whole life plans are called “universal life insurance” and usually have an investment component) is just what it sounds like: a life insurance policy that lasts your whole life.
As long as you keep paying the premium, your death benefit is paid out no matter how long you live. On top of that, whole life insurance comes with a few other potential advantages:
- Builds cash value: Over time, whole life insurance policies accumulate cash value. How much cash value a whole life insurance policy builds depends on the interest-rate environment and how much of your premium is going toward cash value each month.
- Premiums don’t increase: As long as you maintain your policy, you don’t have to worry about rising premiums. If you buy your policy when you’re young, you don’t have to deal with higher rates as you age.
- Borrow against the policy: Since you have cash value, you can borrow against the money that has accumulated. Often, interest rates on a loan against your whole insurance policy’s cash value are lower than what you can get at a bank.
- Some policies pay dividends: Dividends are based on a company’s formula and involve the cash value at the beginning of the year, expense charges, interest credit, and the cash value at the end of the year. By the time you reach year 25, it’s possible to see dividends of $1,500 to almost $2,000 a year.
- Can tie performance to stock market returns: There are whole life insurance plans that are indexed to the stock market. In some cases, depending on market returns and your policy terms, you can capture a portion of those stock market gains.
With these advantages, you can see why whole life insurance premiums cost so much more than term life insurance.
Disadvantages of whole life insurance
As mentioned earlier, the biggest disadvantage of whole life versus term life insurance is cost. Even if you’re young, you might not be able to afford the monthly premium that comes with a whole life policy that’s big enough to cover your family’s financial needs if you pass away.
On top of that, a “regular” whole life insurance policy might not accumulate cash value quickly in a low-rate environment.
Universal plans tied to a stock market index might not do as well as you would like, either. When it comes to indexed universal life plans, The Motley Fool points out that, “Depending on your situation, the total costs paid may net less long-term benefits versus other insurance and separate investing alternatives.”
From an investment returns standpoint, you might be better off getting cheap term insurance and investing the difference in index funds on your own, as long as you have the financial discipline to stick with investing.
Who is whole life insurance for?
Whole life insurance can work well for someone whose insurance goals go beyond making sure their families are taken care of if they pass on before their kids finish school.
Since it can be tapped for a low-interest loan, a whole life insurance policy can supplement (but not replace) your emergency savings. Additionally, you can decide to surrender the policy in return for the accumulated cash value during retirement.
With a big enough policy, the cash value could actually be enough to buy an immediate annuity. You could also invest the cash later to provide another retirement account infusion.
Comparing term vs. whole life insurance
When comparing term versus whole life insurance, start with your needs and your reasons for getting life insurance. A financial professional can walk you through the various pros and cons.
If you need something that will pay off debts and replace your income for a set period of time when you’re gone, term life insurance might be the best choice. However, if you have other financial goals and you’re concerned with being covered for your entire life, whole life insurance might be the way to go.
You can also consider a hybrid approach, like me. Just make sure it’s affordable and meets your long-term financial needs.
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