Life insurance is all about risk and managing that risk.
Insurance companies base their premiums on the likelihood of you passing away during the term of the policy you are insured for.
If you’re in an older age bracket, smoke cigarettes, and have health risks, then there is a good chance you will pay a high premium. If you’re still relatively young, don’t smoke or drink alcohol and are generally healthy, then your premiums will be on the lower side. These are only a few of the many variables that life insurance providers consider when they are assessing risk.
But risk isn’t just something that the providers examine. It should also be factored into the purchasing decision of the policyholder as well. For the most part, the decision comes down to the provider, but one of the biggest questions you need to be asking yourself is what type of life insurance should you buy? Should you go with a term life policy, or is whole life insurance better for your situation?
The term vs whole life insurance dilemma is something that very much should be decided by circumstance, not cost. Both play a role and have their value, but depending on your situation and your financial goals, one might just be the clear winner over the other.
Generally speaking, a whole life insurance policy is more expensive compared to a term life insurance policy. However, it can also build cash value over time, thus it might be recommended for early adopters. Term life insurance on the other hand does not build cash value, but typically has a higher death benefit.
How term life insurance works
Term life insurance is a contract that you sign with the provider of the insurance policy. This contract (the policy) basically states that they, the insurer, will pay a death benefit if you happen to pass away during the term of the policy. This death benefit is valid for as long as you pay your premiums, which you can choose the length of the term. Hence the name ‘term’ life insurance. Typically, term lengths are 10, 20, or 30 years. Term 20, or a twenty year term, is the most common term of term life insurance. Typically, the premiums you pay remain the same throughout the term, unless there are adjustments to your policy.
This type of life insurance is usually taken out as a form of income replacement. Homeowners will often buy a term life insurance policy to match the term of their mortgage, ensuring that the home will be paid for in the event of their passing. Other situations include covering tuition for children in college and spanning the last few years before retirement.
When you shop around for term life insurance :
- Choose a term length that covers the years you’ll be paying the bills and want life insurance in case you die.
- Get a coverage amount your family would need if you were no longer there to provide for them. This includes the above situations as an income replacement.
Term life offers:
- Lower premiums (typically paid monthly)
- High death benefit payouts (to cover your dependents, including spouse)
- No cash value (which means you are unable to pull funds from)
Premiums are generally lower on term life insurance policies because the insurance provider does not have to match dividend payouts or stock market returns in the way they do with whole life or universal life insurance policies. Death benefits are higher for the same reason, not to mention that the risk factor for term life is lower than with permanent life insurance policies. In fact, many policy-holders never collect.
Choosing the amount of term life insurance that you need should involve looking at your expected living expenses for the term of the policy. If you were to suddenly pass away, you wouldn’t want your loved ones to be stuck in a financially challenging position where they are struggling financially. Add up your mortgage and car payments, tuition, living expenses, and other costs that you incur. The amount of your policy should equal or exceed the sum of those costs. In addition, you’ll also have to consider end of life arrangements such as legal fees and funeral costs.
Pros and cons of term life insurance
The most obvious benefit of choosing term life insurance is the price of the premium. A million-dollar term life insurance policy for a forty-year-old male costs are $50 a month on average. Women, who historically live longer than men, will pay less than that.
A whole life insurance policy with the same benefit amount on the other hand, has an average premium of somewhere around $10, 000 per year.
One of the downsides of choosing term life insurance is that you don’t build any cash value. Sure, your death benefit is higher if you compare it to the premium price, but the policy itself is basically worthless until you pass away. And frankly, you want to keep it that way. Not to mention that your insurance coverage expires when the term ends. Signing up for a new term life policy after one has expired will end up costing you significantly more since you’ll be older and may likely have some health issues. For this reason, if you’re considering a term life insurance policy, it might be a smarter financial decision to go with a longer term to keep your premiums lower in the later years of the policy.
How whole life insurance works
Whole life insurance is a term that is often misused to describe a range of other life insurance products. Those include universal life, variable life, and survivorship life. We’ll cover more on each of those below. For now, here’s what you need to know about whole life insurance:
- Premiums are promised not to go up
- Death benefit will not go down
- Minimum ROI on cash value is guaranteed
Cash value for a whole life policy is based on dividends declared by the insurance company. If the company declares a 5% dividend, your policy is credited with 5%. That’s different from universal life, which pays credits based on stock market performance or prime interest rate. Choosing that option could net you a higher return, but you’re also at risk of no return.
It takes ten years to build any significant cash value in a whole life policy. During that time, an early withdrawal will not necessarily be equal to the full cash value. Most insurance companies set a “surrender value” to policies in the initial years that you’re paying premiums. That surrender value will be significantly less than the cash value if you surrender the policy.
The cash value return on investment (ROI) is guaranteed with a whole life insurance policy, as is the death benefit. After a certain period of time, you can withdraw from your cash value or take out a loan against it. Be careful about the withdrawals though. Withdrawing this cash will decrease the amount of your death benefit which is determined by the insurance company.
Pros and cons of whole life insurance
Whole life insurance can give you lifelong coverage and provide extra support during retirement. It’s also an investment opportunity that allows you to build cash value every year that you are insured through the policy. This cash can be withdrawn in small increments when needed, borrowed against, or cashed out for full value after the necessary time period has elapsed. For business purposes, cash value life insurance can be listed as an asset.
The main drawback to whole life insurance is the premium price. You’ll pay a lot more for it than you would for a term life insurance policy. For that reason, whole life policy-holders typically opt for a lower death benefit, trading that off to build cash value instead. Lastly, it also takes at least ten years to accumulate any real value in the policy.
Term life vs. whole life: policy features
|Policy features||Term life insurance||Whole life insurance|
|Choice of policy length||✓|
|Provides lifelong coverage||✓|
|Premium generally stays the same||✓||✓|
|Life insurance payout amount is guaranteed||✓||✓|
|Accumulates cash value||✓|
|Might be eligible for annual dividends||✓|
2020 average life insurance rates
|Person covered||Policy amount||Whole life||30-year term life||20-year term life|
The universal life insurance option
Up to this point, we’ve talked about term life insurance compared to whole life insurance. But what is universal life insurance?
Universal life insurance is another type of permanent life insurance that builds cash value. While it’s often categorized as whole life insurance, there are slight differences. Universal life insurance builds cash values through payouts based on stock market performance, not dividends.
The most popular product in this category is what’s known as indexed universal life insurance. Indexed universal life insurance uses the S&P 500 as a benchmark for its cash value. If the S&P nets a return of 11% for the year, the contribution from the insurance company will be 11% of the cash value of your account. The cash value is built by taking a percentage of your premium payments every month.
Variable and survivorship life insurance
Just because the policy has a cash value does not mean it’s a whole life insurance policy. Variable life insurance and variable survivorship life insurance are both universal life insurance products. They are similar in the way that they work, with one major difference. Survivorship life insurance insures two people and pays out the death benefit only after both have passed.
Variable life insurance is an investment account. You can select investment options for the account that your premiums are deposited in. You can typically choose between Mutual Funds or ETFs. You can also opt to allocate a portion of your premiums to a fixed account that pays a fixed rate of interest—It’s a more conservative option, but yields a guaranteed return.
Survivorship universal life insurance is usually taken out by parents to make sure their children are taken care of. It’s similar to a trust fund in the way it functions as an investment account. By adding the stipulation that both parents have to be deceased for a payout, the surviving partner can continue to pay the premiums and save for their children’s future.
Whatever you choose, whether it’s term life, whole life, or universal life, just make sure you have some type of insurance to cover your loved ones in the event of your passing. Even for the young, tomorrow is not guaranteed, especially in this crazy world we live in. Start planning today. Life insurance is as important as a retirement fund, if not more so.
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