Chances are, term life insurance is the best life insurance for you. But with all the different life insurance options out there, some of which might be heavily marketed to you (ahem, whole life insurance), you should try to understand why term life insurance is best for most people and why the other products are usually less desirable.
Why Buy Term Life Insurance?
Term life insurance covers you for a specified number of years, often 10, 20 or 30. If you die while you’re covered, your heirs receive the face value of your policy—the sum you purchased coverage for, perhaps $100,000 or $500,000 or $1 million.
The premiums you pay for term life insurance coverage are the same every year, from the time you first take out the policy until the time it expires, as long as you purchase a level term policy, which is the most common option. And they’re quite cheap compared to the amount of coverage you get in return.
Here’s an example: You’re a 30-year-old woman in excellent health living in California. You haven’t used any tobacco products in the past three years. You want a $1 million policy with a 30-year term. Your premiums with one major carrier would be $660 per year, or $57.45 per month.
The younger you are and the better your health when you apply, the less expensive life insurance is. Depending on the company offering insurance, the following factors can increase your premiums:
- High cholesterol
- Higher than normal blood pressure
- Family history of cancer or heart disease
- Traffic violations in the past 24 months
- DUI violation
- Sedentary lifestyle
- History of drug or alcohol abuse
Term life insurance pricing is straightforward and transparent; you can easily get quotes online from various providers. Those quotes will be adjusted for your unique circumstances depending on what medical underwriting uncovers. But an insurance agent, and often an insurance website, can give you an idea of what health category you’ll fall into and what your premiums will be even before you apply.
Level term life insurance is easy to understand. You’re unlikely to make a big mistake when you buy it—at worst, you might buy too much or too little coverage. Once you have a policy, there’s nothing further to do; just pay your premiums on time and keep your policy beneficiaries up to date. Sit back and relax, knowing your family is covered.
Pricey Alternative: Permanent Life
Unlike term life insurance, which expires when you reach a predetermined age, permanent life insurance stays in force until you die. It costs much more because the insurance company is definitely going to have to pay out the policy’s face value when you die, unless you stop paying your premiums.
When we say permanent life insurance is dramatically more expensive, what do we mean, exactly? That same 30-year-old woman in our term life example could get a whole life insurance policy—the best-known type of permanent policy—from the same major insurer for a whopping $9,370 per year, or $815.15 per month. (Other types of permanent life insurance include universal life, variable life, variable universal life, burial insurance and survivorship life.)
Permanent life insurance also costs much more because these policies usually have an investment component with associated fees and commissions—including a large commission for the agent who sells you the policy. And with some of these policies, if your investments don’t perform well enough, you can be required to come up with more cash to keep the policy in force.
It’s this investment component that is so hard for people to understand and that is generally a waste of money. That’s why you may have heard the old life insurance adage, “Buy term and invest the difference.” When you take what you saved from purchasing term instead of permanent life insurance and invest the money on your own, you will have full control over the investments and the fees you pay. If you follow the conventional investment wisdom to buy and hold inexpensive, well-diversified mutual funds and exchange-traded funds (ETFs), you will likely come out ahead over what you would earn through the investment component of a permanent life insurance policy.
The Cash Value Component
Permanent life insurance also has a cash value component, and it’s one of the features agents use to sell policies. As you pay premiums, part of your money goes to what’s called the policy’s cash value. Cash value is not the same as the policy’s death benefit. You can borrow against the cash value (and pay interest to the insurance company, even though you’re borrowing “your” money) or you can use it to pay premiums.
But if you die with a loan outstanding, your loan balance gets subtracted from the policy’s death benefit, detracting from the policy’s true purpose of providing for your heirs. Perhaps the worst part about a permanent policy’s cash value is that if you don’t use it while you’re alive (which has negative consequences), you lose it when you die: The insurance company keeps it! So although the death benefit goes to your beneficiaries, the cash value does not.
Yes, the cash value of a permanent life insurance policy grows tax free, and yes, a good policy pays dividends, which are basically just a return of part of your inflated premium. (Both of these things are also true when you buy an S&P 500 index fund within a retirement account such as a 401(k) or IRA. Yes, you can borrow against the cash value of your whole life insurance policy, but you can also borrow from your retirement account, and the interest you pay goes back to your own account.
A Choice for Wealthy Families
Why, then, do people buy permanent life insurance? Whole life insurance can also be used to provide for a surviving spouse who relies on a pensioner’s income, if the pension will terminate or shrink when the pensioner dies. It can also make sense for some wealthy families. Whole life policies are protected from creditors in some states—but then, so are some retirement accounts.
In addition, life insurance policy proceeds are usually not taxable, so they can be a way to pass down wealth to the next generation without paying estate taxes for individuals whose estates are worth more than $11.18 million and couples whose estates are worth more than $22.36 million (as of 2018). Families in these circumstances may want to use permanent life insurance to provide the cash to cover an estate tax bill so that heirs aren’t forced to liquidate assets such as a family business or family real estate holdings to pay taxes. But they must be sure to structure the policy ownership correctly or the policy’s death benefit will become part of the estate and be subject to taxation.
Term Life’s Advantages
Term life insurance is simple, inexpensive, and for most people lasts long enough to provide for dependents. By the time a term policy expires, the idea is that your children are self-sufficient adults and your spouse would rely on your retirement savings. Permanent life insurance goes beyond simply providing coverage for a limited number of years and is much more expensive and much more complicated as a result. Because term life insurance is inexpensive and easy to understand, it’s the best life insurance for most people. Permanent life insurance, on the other hand, might make sense for some very wealthy families who are financially sophisticated enough to understand the policy’s intricacies.