If you are considering buying life insurance, you are probably trying to figure the difference between term life and whole life insurance. The distinction between the two may seem small, but the differences are important.
Today we will walk you through the difference between term life vs whole life insurance so you can determine the right policy for your family.
Before we begin, let’s cover what life insurance is.
What Is Life Insurance
Life insurance is a product offered by a company to guarantee financial compensation upon the death of an individual. If the insured person passes away within the legal terms of the contract, the beneficiary will receive a monetary payout specified in the contract. This life insurance payout is typically in a single lump-sum payment.
At its most basic level, the point of life insurance is to help support your loved ones when they can no longer rely on your salary or income after your untimely death.
Yes, I 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.
I learned that the hard way. My dad was diagnosed with brain cancer at the age of 32, shortly after he was married. Since he was the sole breadwinner at the time, he should have gotten life insurance to take care of my mom (they didn’t have kids yet). By the time he was diagnosed with cancer, it was too late for him to qualify for life insurance.
When I was a 7-year-old he died from cancer and our family never recovered financially and I was raised in poverty. I don’t want the same thing to happen to your loved ones.
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, and How Does It Differ From Whole Life?
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).
In other words, the policy pays out a specific amount of money if you die while the policy is in force. However, the policy only lasts for a set amount of time.
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. You get to pick the payout amount and the term.
The price of the policy varies depending on your choices and other risk factors. In general, the higher the payout and the longer the term, the higher the monthly payment (premium) will be.
As mentioned earlier, other risk factors like your age and health will also be factored into the price. Some policies require blood work and a medical exam, although some companies like Haven Life, Bestow, and Sproutt also offer policies that don’t require a medical exam. Whether you ultimately need a medical exam or not, you can be sure that the insurance company will still review your previous medical information, drug prescriptions, underlying health issues, and even a motor vehicle report.
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.
At the end of the day, the insurance company gathers as much information as they can in order to determine what to charge you for your policy.
Why Would I Want A Term Life Insurance Policy If It Doesn’t Last Forever?
There are many reasons why term life insurance is the right choice for many 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. And for many people, this is actually a good thing!
The purpose of term life insurance is to essentially buy yourself time to save up money for your loved ones. If you die before you have enough money saved up for them, then you have the policy to fall back on. Once you have earned, saved, and invested enough money, you no longer need to insure against your death. At that point, you’ll essentially be self-insured since your family can use the wealth you’ve accumulated to live off of.
This means that you won’t need to pay for a policy when you no longer need it.
Some people will still decide to purchase life insurance even if they don’t need the payout just to be safe. You never know what your situation will be like 20 or 30 years from now.
Put simply, if the assets you leave behind are enough to support your loved ones, you no longer require life insurance, but you still may feel more comfortable with a policy just in case. It’s a personal decision.
A common rule of thumb is to get a policy that will last long enough so that your youngest child will be done with college.
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).
- Generally less expensive when compared to whole life insurance.
Cons of Term Life Insurance
- The insurance expires when the term is complete, so it won’t necessarily last your whole life.
- Some plans have premiums that are not fixed, so make sure you fully understand the plan you go with.
What Is Whole Life Insurance, And How Does It Differ From Term Life?
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 or 90 years. The catch is that the premiums (monthly payments) are much higher compared to a term life policy.
Upon your death, your beneficiary 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.
One key point is that you must ALWAYS make payments to keep the policy in good standing and in force. 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 canceled.
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).
- 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.
Term Life vs Whole Life Insurance: Which One Is Right For Me?
For many people, the right answer is term Life Insurance!
There are a few reasons why I generally prefer (and have) a term life insurance policy. It all comes down to cost, the amount of coverage, and necessity.
The first reason is cost. Term policies are generally more affordable. This means that you will be able to afford more coverage during the years when your family is likely the most vulnerable.
You might decide that 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 might decide 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) Policy||Whole Life Insurance Policy|
*Numbers are based on quotes for a healthy 29-year-old male
For this reason, it could make 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.
This example is an oversimplification because it doesn’t take into account factors other than cost, but it just highlights the fact that there is a significant price difference between the two products. Especially when you realize you’ll have to pay the whole life policy for the remainder of your life.
If Term Life Insurance Is Better, Why Do Many Insurance Salespeople Recommend Whole Life Insurance?
Be mindful of incentives whenever you meet with anyone selling anything. Their livelihood depends on it so your incentives might not always be perfectly aligned.
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 could be), 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 salesperson 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 above) from your policy alone. As you can see, your business is quite lucrative for them. They might 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, 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:
- Your 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.
- Your Income: Calculate your gross salary and multiply it by 5. For example, if your salary is $45,000 that would be $225,000.
- Your Future Obligations (Like Kids’ 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. At the same time, $1 million is a heck of a lot better than nothing! Don’t lose sight of that if you can’t afford a policy that’s as big as you would like it to be.
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 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!
Where Can I Get A Term Life Insurance Policy?
For healthy individuals, we love online insurance companies like Haven Life, Bestow, and Sproutt because they generally don’t require a medical exam and you can get your results (and coverage) in as little as 15 minutes).
My recommendation, if you are in the market for a term life insurance policy, is to quickly get quotes from all 3 and compare them so you can go with the best one.
Francisco Maldonado, MD is a personal finance expert who was raised in poverty by a single mother and had to learn everything about personal finance on his own. In addition to running The Finance Twins with his twin brother, he’s been featured on Forbes, Business Insider, CNBC, US News, The Simple Dollar, and other top publications. Francisco is a physician who borrowed over $200,000 to pay for his medical training and understands debt payoff strategies and frugal living. He received his M.D. from the Mayo Clinic School of Medicine, the most selective medical school in the country, and a Bachelor’s degree in physiology from the University of Minnesota. He is currently a radiology resident at Northwestern University.