Term vs whole life insurance
In this post, I am going to discuss the differences between term life insurance and whole life insurance.
Insurance is one of those things in life that’s necessary because of life’s uncertainties.
I could finish this post, go outside for a walk and get hit by a car, and that’s all it takes.
Most likely we’re all eventually going to need life insurance at one point or another throughout our personal and professional lives.
The important question to ask is which life insurance is right for me? Is it term life or whole life insurance?
Let’s find out.
Term life insurance
What is term life insurance?
Term life insurance provides coverage typically for a set period of time. Most people will elect to go with 20 to 30 years.
The thing with term life insurance is that you can go less, let’s say 10 years or more, let’s say 40 years if you so desire dependent on whichever term suits your needs.
So let’s just stick to 20 to 30 years for simplicity’s sake.
If you decided to buy term insurance for 3o years and if you pass away during this time period then your designated beneficiary is paid the death benefit of whatever the policy is.
It’s that simple.
Let’s say you signed up for a policy that will pay out $500,000, if you passed away during the period of your active term then your beneficiary, typically your spouse or children will get that amount awarded to them.
One of the advantages of term life insurance is that it’s affordable when compared to whole life insurance.
Term life insurance is straight forward. Let’s say you’re paying $30 per month for a $500,000 policy. Your premium each month is going directedly into your coverage.
You’re not building a cash value, you’re not investing that money, and you’re not making any interest in that money.
In a way, term life insurance is similar to car insurance. You’re paying a set amount in order to get a certain amount of coverage.
Pros and Cons
- Great choice for income replacement upon death
- Debt payoff
- Ideal for business policy (key person insurance)
It’s typically recommended that your term life insurance payout amount is 10 to 12 times your annual salary.
So for a pharmacist making $126,000 per year, you’re looking for a policy payout of at least $1.2 million.
This amount is hopefully enough for your spouse or children to replace the lost income.
The idea is that your spouse and/or your children can take the lump sum amount and invest it into the market and live off the interest that would have been paid to you as your salary.
- Costly to renew
Let’s take the example of a 30-year-old male buying a plan for 30 years. When he’s 60 years old, it’s obvious that the premium will be significantly higher at that age.
One of the reasons that your life insurance premium is lower when you’re younger is that you carry fewer risks.
When you’re 30, you have a lot more life to live, you’re generally healthier, there are fewer health risks.
When you are older, the opposite is true. You have less time to live, more health risks meaning the policy has a higher chance of being paid out which means the premium has to rise in order to make the policy more viable for the insurance company.
Whole life insurance
What is whole life insurance?
Three components of whole life insurance.
- Death benefit
- Cash Value
Cash value is what gets accumulated and what insurance salespeople, insurance agents try and sell you on.
You can think of cash value as the savings component or the investment component of whole life insurance.
When you pay your premium, a big part of that is going towards funding the death benefit for the first five to ten years.
Insurance agents will lead to you to believe that the premium you’re paying is going toward the cash value of your policy.
However, in reality, only a small portion of this money is going toward the cash value component of your policy.
Most premiums in the early stages are going towards the commissions of the salesperson and administrative fees. And as mentioned earlier, funding the death benefit.
Insurance agents will point out that if you have a cash value in your whole life insurance, you’ll be making 10 to 11 percent in the market, your money will grow and it’ll be tax-deferred and lastly, it’s your money.
Keep in mind that the 10 to 11 percent growth is usually advertised for a few specific whole life insurance. Mainly index universal life insurance (IUL) and variable universal life insurance (VUL).
(IUL and VUL is outside the scope of today’s discussion).
However, this is an incorrect assumption.
After all of the fees are taken into account, you’re looking at 1.5% to 2.2% average annual rate of return.
This rate will rise only after the initial 5 to 10 years when the bulk of the fees are paid off.
Another kicker is that your beneficiaries are only entitled to the death benefit when you pass away.
What happens to your cash value that’s been promised? The cash value amount will be absorbed by the life insurance company.
Fortunately, Investopedia has you covered, their article discussed 6 ways to capture the cash value in life insurance.
One more thing to point out is that you have no choice in how the life insurance company applies the premium.
In other words, you cannot choose the percentage of your premium that will go toward your cash value. The policy you signed up for dictates that.
The only way to get your cash value money back is to cancel and surrender your policy.
This means that you lose the death benefit, in return the life insurance company will cut you a check for whatever the cash value is.
So in summary, you lost your insurance just to get your money back that grew at a very poor rate.
These are all the downsides of whole life insurance.
Benefits to whole life insurance
One of the benefits of whole life insurance is that the cash value portion is non-taxable.
As long as the cash value portion does not exceed the total premiums that you paid.
The money exceeding your total premium is subject to your regular tax rates.
Quick recap for some of the positives of whole life insurance.
- Coverage for life vs 20-30 years for term life insurance
- Fixed premium
- Death benefit goes to your designated beneficiary
- Very expensive
- Inflexible (no control of premium allocations plus admin fees)
- Cash value accumulation is slow (first 5 to 10 years is going to death benefit)
- Cash value does not go to your family
Term vs life insurance recap
It’s important to know if you even need life insurance in the first place. NerdWallet has a good guide to see if whether you need life insurance or not.
In general, if you’re the sole provider and/or a business owner with assets to protect then life insurance makes sense for you.
However, when it comes to term vs life insurance, in my opinion, term life insurance makes the most sense.
If you need life insurance, go for a term life insurance and invest in either target-date funds or index funds.
More than likely, a 30-year term life insurance should be enough.