Unlike a lot of answers to life insurance questions, this one’s easy: Term Insurance is better.
Let’s start with some definitions, and remember if you ever get confused swing over to our Glossary where you can keep track of difficult words and concepts.
Term Insurance is a flexible insurance plan that lasts for a limited period of time, and that provides life insurance coverage at a fixed rate of payments.
Term insurance is the traditional form of life insurance and the one most people think of before they start researching insurance plans. (Incidentally, I just wrote a blog post for people who are just starting to think about insurance: I Don’t Have Life Insurance – Where Do I Start?)
The idea is you pay insurance for a “term” (a period of time usually between 10 and 30 years) after which coverage renews. When your term renews, coverage at the previous rate of premiums is no longer guaranteed, your new term will be at increased rates. Our clients always have the option to re apply for the cover at standard rates.
When an insured person passes away, term insurance pays the face amount of the policy to the named beneficiary tax free, which is what most people expect from an insurance company.
Whole life insurance is fairly different. Whole life insurance is a life insurance policy that exists for the insured’s entire life, and it doesn’t expire at the end of a “term.”
Whole life insurance came about in response to certain term insurance policy holders who outlived their plan’s time period and were upset about paying insurance for years with nothing to show for it.
Whole life (“permanent” or “cash value” as it’s sometimes called) is basically a way to accumulate wealth thanks to an investment component, which complements the insurance component. The idea is invest accumulated premiums in stock, bonds, or other market instruments. The policy then builds cash value, against which you can borrow money against, or you can cash in the policy and take the money out permanently.
One of the problems with whole life is that it’s expensive, since you have to pay for insurance as well as the investment portion. The idea is that the longer the policy has been active, the higher the cash value as the money earns interest and/or dividents. Keep in mind that although you’re paying higher premiums, they don’t change at all for your whole life. Term insurance on the other hand, does increase.
The downside to whole life is that management fees and commissions tend to eat into your money, and insurance companies usually invest primarily in fixed-income securities, which means that the savings investment is subject to interest rate and inflation fluctuations.
Many people, including myself, see whole life as a kind of forced savings, or forced retirement plan over which you have little control. It’s difficult to tell what your return on investment will, or even how much of your premiums are going towards the insurance, and who much towards the investment.
Plus, most insurance analysts note that whole life policies hardly ever yield a decent return unless they’re held for more than 20 years. And obviously, there are other more transparent ways of investing money at your disposal.
Here’s an example from Smartmoney that illustrates my point with a comparison between a Term Policy and a Whole Life Policy:
Say a 40-year-old nonsmoking male has a choice between a $250,000 Met Life universal policy with a $3,000 annual premium and a same amount of renewable term coverage with a 20-year fixed premium of $350.
At the end of one year, the universal policy, assuming it paid 5.7% per year, tax-deferred, would have a cash value of exactly zero (cash value is the amount you would get back if you canceled the policy).
But say he had instead invested $2,650 (the difference between $3,000 and $350) in a no-load mutual fund that averaged a total return of 10% annually.
At the end of the first year, he’d have $2,841, accounting for taxes on the earnings at a 28% rate. At the end of 10 years, he would have accumulated more than $46,000 in after-tax savings in the mutual fund.
Over the same period, the cash value of the policy would have climbed only to $31,819.
Of course this is only one scenario that fits the needs of a single 40 year old nonsmoking male – everybody’s age, health, insurance company, and insurance policy is different. Interest rates and dividend rates fluctuate too, which makes Whole Insurance more complex to analyze, and more difficult to predict as a favorable long term insurance policy.
As you can see, there are many variables when comparing Term and Whole Life insurance. As always, your best bet is to start by emailing us here at Bravia Life – we can look at your profile and then talk through the life insurance policy options that fit your unique needs.
Everyone’s different, and we’d love to help!