While all life insurance policies serve the same general purpose – providing funds to your family in case of your death – not all types of coverage are equally ideal for you and your family’s long-term financial future.
Like the IRS, life insurance companies can make it difficult to understand all the fine print, terms and conditions. Sales representatives, agents, brokers and financial planners can also make things worse by marketing certain policies because of the huge commissions they earn after each sale.
When it comes down to it, there are only two main, overarching types of life insurance you need to worry about: term and permanent life insurance. Once you learn about the pros and cons of each, you can pick a specific kind (i.e. return of premium, level term, survivorship, no exam, guaranteed issue, etc.) within that category.
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Term vs Whole vs Universal Life Insurance
Term Life Insurance
The point of term life insurance is to cover a person for a set amount of time. The policyholder pays a fixed premium during the term period, which can be from 5 to 30 years, and if the insured person does not pass away while the policy is in force, the contract expires without a payout. Otherwise, the insurance company will pay out the death benefit to your beneficiaries.
In regards to premiums, traditional term life insurance is the cheapest because it is temporary and issued through a strict underwriting process. The company uses actuary tables to calculate your mortality risk and rates based on your age, current health, family medical history, occupation, and other factors.
At the risk of sounding morbid, each year you live is a year closer to death, and because of this simple fact, your life insurance quotes will never be cheaper than when you were young and healthy.
Pros and Cons of Term Life
Although term life insurance rates are initially the cheapest form of coverage, term life expires after a specific period of time and must be renewed or replaced. Renewal rates are usually substantially higher than rates for the initial policy. Term life does not accrue a cash value and if an you become ill or elderly during the initial term, you may not be able to obtain a new policy.
Whole Life Insurance
Unlike term life, whole life insurance policies remain in effect for your lifetime, assuming you continue to make premium payments. Whole life insurance, which is a type of permanent coverage, also has an investment component known as cash value.
Think of it as a forced savings account whereby a portion of your premiums are diverted into this investment account. This is one of the reasons whole life rates are generally 5 to 10 times higher than term rates.
Whole life premiums are averaged over the life expectancy of the insured individual, which may be 50 years or more. Once the policy is issued, the rate remains fixed for the policyholder’s lifetime and the policy can only be canceled for non-payment of premiums. Even if the insured person becomes uninsurable due to poor health or age, a whole life policy remains in force.
As we mentioned, part of the premiums of whole life is diverted into a savings feature. Some of the best rated life insurance companies pay a guaranteed rate of interest of about 4% on the cash value. Given the low interest rate environment, that’s definitely better than a checking or savings account, even a high yield one.
You can then choose to fully withdraw the cash value from the policy, effectively canceling the policy, or you can use the money as collateral for a low interest loan.
Pros and Cons of Whole Life
Unfortunately, whole insurance has a fixed death benefit which cannot be changed as financial obligations change over a lifetime. This means that you may or may not have enough life insurance to meet your needs, while at other times, you may be overpaying for more life insurance than necessary.
Moreover, initial whole life insurance rates are higher than those of term or universal, making it less affordable for most American households on a budget.
Overall, unless you are a high net worth individual seeking tax-advantaged investments or estate planning strategies to minimize estate taxes for your heirs, life insurance isn’t a good investment. It is an overpriced life insurance policy with a low yield compared to other investment opportunities.
Universal Life Insurance
Universal life insurance is another form of permanent life insurance which has a minimum and maximum premium payment, offering a bit of flexible to policyholders. Unlike fixed whole life premiums, if the cost of administering a universal life policy increases, the minimum payments increase.
Your contribution also determines the amount of money that is diverted into the investment account.
The cash value of universal life is invested in financial markets, resulting in greater volatility within the investment value of the policy. If the cash value of the policy reaches zero due to investment failures, the policy lapses. Universal life insurance rates usually rank somewhere in between term and whole.
Compare Life Insurance Online
Just like you would any product or service, it is best to research and compare carriers and policies. By comparing types of coverage, pros and cons, companies, and premiums, you increase your chances of finding the best, yet affordable policy to meet your needs.
This usually means buying a cheap term life insurance policy that offers you all the coverage you need, then taking the difference in premiums and investing. Max out your 401K, or if you don’t have access to one, open up a Vanguard or Fidelity account and invest in a passive index fund, such as an index fund that tracks the S&P 500.
In the long run, your term life policy will protect your family and offer you peace of mind. The premiums won’t be a burden on your budget. And hopefully you outlive your policy to enjoy the retirement savings you’ve built!