Our last post introduced you to the basics of life insurance, and whether it is something that you need.
As a reminder, the main purpose of life insurance is to provide for your financial dependents in the event of your death. Your financial dependents may include your spouse, children, parents, or anyone else who relies on your income.
Yes, we know this topic can be sad and painful to think about, but it’s incredibly important to have a back-up plan for your loved ones.
It’s also good to remember that not everyone needs life insurance! However, if you do need life insurance, it’s important to have it so that you don’t put your loved ones at risk for undue financial hardship. The last thing you want is for your loved ones to be unable to meet their basic needs after you are gone.
If you aren’t sure if you need life insurance, read our last post here!
Now, let’s cover the differences between the different types of life insurance and help you decide which type is right for you!
What are the Different Types of Life Insurance?
There are two main categories of life insurance everyone should be familiar with. They are:
- Term Life Insurance
- Permanent Life Insurance
The most common type of permanent life insurance is Whole Life Insurance, so that’s what we will focus on in this article.
Other types of permanent life insurance include:
- Universal life insurance – These policies are a type of permanent life insurance giving consumers flexibility in the premiums, payouts and the savings elements of the policy.
- Variable Life Insurance – These policies aim to combine life insurance and investments by investing the cash reserves.
- Variable Universal Life Insurance – As the name implies, these policies are essentially a combination of Universal and Variable Life Insurance.
- Single Premium Life Insurance – A type of insurance where you pay the entire premium up-front in a lump sum. The minimum premium to participate is usually $5,000.
Most people will be looking at either Term Life Insurance or Whole Life Insurance so we will be focusing on those two.
What is Term Life Insurance?
Term life insurance is a type of life insurance where you pay a specific amount (the premium) to keep the policy in effect for a specified amount of time (the term). The term and the death benefit amount is set by you (the person who purchases the policy). The premiums are determined by the underwriter (the insurance company).
Terms are usually 5, 10, 15, 20, or 30 years. Ultimately, you get to decide which term is best for you.
For example, you can purchase a 20 year term with a $500,000 death benefit or a 10 year term with a $600,000 death benefit. The term and benefit amount are up to you! The price of the coverage depends on both the term length and the death benefit amount you choose.
Your age and health will also be factored into the price, and most policies typically require blood work and a medical exam. This is typically referred to as medical underwriting. One typical exception to medical underwriting is if you get term life insurance through your employer. This is a great option for those with chronic health problems, since that would make conventional life insurance coverage very costly.
Why Would I Want a Life Insurance Policy that Doesn’t Last Forever?
There are many reasons why term life insurance is the best choice for most people!
First, a huge benefit is that term life insurance has a fixed term. This type of policy is not meant to cover you for your entire lifetime. Many people assume that life insurance always lasts your entire lifetime, but that’s not the case here. This is actually a good thing!
The purpose of term life insurance is to financially insure your beneficiary(ies) until you have saved enough money to support them on your own. Once you have earned, saved, and invested enough money, you no longer need to insure against your death! Since your loved ones will inherit your assets/wealth, they’ll be able to be provided for without life insurance. This is a great thing because it can cost you a lot of money to pay for insurance that you don’t need.
To drive this point home, paying for insurance when you don’t need it would be like buying insurance for a boat when you don’t have a boat. Or paying for a car wash when you don’t even have a car! It’s a complete waste of money! The same thing applies to paying for life insurance when you no longer need it.
The best part is that you’ll be able to enjoy all of the money you save in insurance premiums while you’re still alive!
Put simply, if the assets you leave behind are enough to support your loved ones, you no longer require life insurance. In fact, you’d be better off saving the money you’d spend on the insurance premiums and investing it.
Pros of Term Life Insurance
- You can choose the term of the policy, so it only lasts as long as you need it. You won’t have to pay for insurance that you don’t need.
- Easy to understand! You basically only need to know 3 things: the term (years), the premium (your monthly or annual payment) and the death benefit (the amount your beneficiaries would receive).
- Compared to whole life insurance, the premiums are much lower, which allows you to save and invest more of your income.
Cons of Term Life Insurance
- Insurance expires when the term is complete. For example, there’s a chance you can die a day after the policy expires and your loved ones won’t get a penny. That’s okay though, because you should have enough saved up to cover their expenses by then.
- Some plans have premiums which are not fixed, so make sure you fully understand the plan you go with.
What is Whole Life Insurance?
In contrast to term life insurance, whole life insurance provides permanent coverage from the day the policy is purchased until the death of the insured individual, as long as you make and stay current on all of the payments. It does not matter if you live for another 10 years after buying the policy or 90 years.
Upon your death, your beneficiary(ies) will get the death benefit as long as the policy is in good standing (all premiums paid). Typically, the premiums are the same throughout the entire life of the policy. This means that when the insured individual is young and healthy they are probably overpaying for the benefit, but once they are old(er) or in poor health, they will be underpaying the value of the benefit.
If you make payments for 25 years and then stop making payments and die a year later, you’re loved ones won’t receive the death benefit payout! We can’t stress enough that your account must be paid and current at the time of death. It’s important to know that many people do NOT keep up with the costly payments, and their policy gets cancelled. Ask your grandparents and see.
Another unique aspect of whole life insurance is that it accumulates a cash value. Each month when you pay your premium, part of the money goes towards the life insurance policy and another portion goes towards the cash value. As you pay more and more premiums over the life of the policy, the cash value will grow tax-free. You can also borrow money against the cash value of the whole life insurance policy. The cash value can also be withdrawn if you surrender (cancel) the policy, but there can be a hefty fee associated with this.
Pros of Whole Life Insurance
- The premiums are fixed and will never increase.
- The cash value of the policy can be taken out as a loan, and the cash value can grow tax-deferred. The ability to borrow against the cash value can also be a con since you have to pay interest to borrow your own money.
- Your beneficiaries are guaranteed to receive the death benefit payment regardless of when you die (even it’s in 90 years from now), as long as all of the premiums have been paid.
Cons of Whole Life Insurance
- Compared to Term Life Insurance, the premiums are very expensive (roughly 10x to 15x higher). This means that you will have less money to save and invest on your own. This is money that you won’t be able to use while you are alive.
- Terminating or surrendering a whole life policy can be very costly.
- Whole life insurance is permanent, so you could end up paying for it even once you no longer need it. Remember, this is like paying for boat insurance even after you’ve sold your boat. It could be a big waste of your money.
Term vs Whole Life Insurance: Which One Should I Get?
For the vast majority of people, the answer is Term Life Insurance!
There are a few reasons why we strongly suggest Term Life Insurance for the majority of people who need life insurance.
Since you are reading this site, you are acquiring the tools necessary to build an awesome financial future. With this knowledge, you will eventually become financially independent and will be able to afford the retirement of your dreams. This means you will eventually no longer need life insurance!
For this reason, it does not make any sense to continue to pay the whole life insurance premiums once you’ve saved your nest egg and have a significant net worth. Once your house is paid off, you’re debt free, and have enough to retire comfortably you do NOT need life insurance.
Additionally, the premiums for term life insurance are significantly lower than for whole life insurance. To see an example comparison in the premiums, we created the table below to highlight the price comparison for a healthy 29-year-old male.
Example Life Insurance Premiums
|* $1,000,000 death benefit||Term Life (20 year term)||Whole Life|
*Numbers are based on quotes for a healthy 29-year-old male
For this reason, it makes the most financial sense to take out term life insurance and invest the difference you would have paid for whole life insurance in low-cost index funds. You’ll be able to end up with more money than the cash value of a whole life insurance policy if you save and invest the difference on your own.
If Term Life Insurance Is Better, Why Do Many Insurance Salespeople Recommend Whole Life Insurance?
A word of caution: be careful if you meet with a whole life insurance salesperson. Remember, they are incentivized and rewarded for selling as many whole life insurance policies as possible. Even if your best option is term life insurance (and it probably is), they’ll push whole life insurance hard because the commissions they earn are MUCH higher for permanent life insurance policies!
On a typical whole life insurance policy, an insurance salesperon makes a handsome commission for each policy (as much as a year’s worth of premiums). Yup, if you sign on the dotted line, they can earn roughly $7,560 to $8,400 (based on the policy below) from your policy alone. As you can see, your business is quite lucrative for them. They have their own financial future in mind, not yours.
This just goes to say that you should be careful when making important financial decisions because the ramifications can be large. Determine what kind of insurance you need (most people need term life insurance), and then find the best price possible. Obviously, not all salespeople are only looking out for themselves, but it’s something to be aware of.
How Much Life Insurance Do You Need?
You will need a policy large enough to cover 3 things:
- Debt: Your policy should cover ALL of your debts and liabilities. Add up all of your debt including credit card debt, car loans, mortgages, unpaid taxes, etc.
- Salary: Calculate your gross salary and multiply it by 5. For example if your salary is $45,000 that would be $225,000.
- College: Finally, set aside money to help your children pay for college if this is something you’d like to do for them. Estimate the amount by taking the cost to attend a local 4 year college (tuition + room / board) and multiplying it by the number of children.
Once you have calculated these three numbers, add them up. This final sum is the minimum amount of coverage that you should aim for.
We recommend that you take inflation into account, especially if you have a longer term (20-30+ year policy). You can think of inflation as the increasing cost of living over time. I know $1,000,000 sounds like a lot, but in 20 years it won’t go nearly as far.
What If I Want a Larger Policy?
We recommend the above amounts because this will allow your family to be debt free and have 5 years to recover your lost salary if you die unexpectedly. This will give your loved ones enough time to get back on their feet. It will also lessen the burden on your spouse to save for your kids’ college educations.
Keep in mind that you can always choose to have a smaller or larger policy. This is obviously a very personal decision and it depends on your economic situation, and the kind of coverage and lifestyle you’d like your loved ones to have. As we mentioned above, the larger the policy, the higher the cost will be.
There’s a chance you don’t even need life insurance!
Finally, remember that if you are debt free and have enough saved for retirement, you do NOT need life insurance. You have insured yourself and can save on paying the premiums! Once you have reached financial independence, you are better off taking that saved money and investing it wisely!