If you are considering getting life insurance, make sure that you are looking at term life insurance, and not whole or any other type of policy. There are a lot of insurance options out there, and you usually have to go through an insurance broker who has a financial incentive to steer you into something that costs more than it should. You could very well end up with something more expensive than you really need.
Term vs. Whole Life Insurance
Term life insurance is just like it sounds: it is life insurance for a set term. A term can range anywhere from 1 year up to 30 years, or sometimes even longer. On the death of the insured, as long as it falls within the term, it pays out the amount of the policy to the beneficiary.
Whole life insurance, however, takes everything you get with a term policy and attempts to add an investment component. Some of these investment components are simple money market funds that accrue interest, but others invest in bonds or seek to mimic indexes like the S&P 500. The policy builds a cash value in this investment component which you can borrow against or cash out after a certain time. The most common types of whole life policies are traditional whole life, universal whole life, and variable whole life.
Whole life insurance is more expensive because you’re not only paying for insurance, but you’re also paying for the investment portion.
The Life Insurance Math
Let’s look at a 25 year old male, excellent health, and non-smoker. The policy is for $1,000,000 for a 30 year term.
For a term policy, you would pay about $80 per month, or about $960 per year.
For a traditional whole life policy, while rates and accounts vary greatly, you can see a premium payment of around $250 per month, or $3,000 per year. Remember, this is much more expensive than a traditional term life policy.
Let’s just look at the difference between these two policies. The term policy has no cash value, but you get to keep the difference in the premium you would have shelled out for the whole life policy ($2,040 annually).
After 10 years, the cash value of the whole life policy would be roughly $28,000. This money is also after-tax, since it is an insurance investment.
After 10 years, if you just invested the difference between the policies, you’d have a before-tax investment value of $36,321, assuming a 8% rate of return. Even if you include taxes at the 28% rate, you would still see an after tax return of $31,691. This is over $3,000 more than the cash value of the whole life policy.
What You Need To Know
It is also essential that you keep this is mind: term life is simple – a straight term, nothing fancy. But whole life is a complex instrument that is designed to return more than a term life policy to the insurance company.
Since it is complex, you also have to speak to an insurance representative to even get a quote, and policies vary widely from insurer to insurer. The most easily compared metric on whole life policies is the internal rate of return (the yield on the policy minus fees). With a little analysis, you can figure out if the policy will provide a decent return, and you may even be able to figure out the minimum cash value at any given time.
For warning, a whole life policy usually doesn’t even yield a worthwhile return unless you hold it for over 20 years. Then it starts to be a little better, but still not usually on par with outside investments. Second, whole life policies usually have surrender charges, so if you accidentally bought one and now want to switch to a term, make sure you read the fine print. You could see large fees required to get out of your whole life policy.
Finally, since 30 years is a long time, you want to make sure that the insurance company you are insured with will be around. Insurance companies are rated by two main companies – S&P and AM Best – who look at the company’s ability to pay claims. Most financially sound insurers are rated AAA, so make sure that you go with the best.
Readers, what are your thoughts on the term vs. whole life insurance debate?