Term vs. Whole Life Insurance: Which Is Better?

When you're young - say during college or in your 20s and 30s - life insurance is the least likely thing on your mind. Seriously, I've yet to meet a college student or recent graduate who's given any thought to life insurance. But there are a lot of reasons why a millennial should consider life insurance:

• Rates are best when you're young and healthy
• You have private student loans with a cosigner
• You're getting married and want to protect your spouse or family
• You have children

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.

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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 or savings 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 life policies that combine "other stuff" with life insurance are traditional whole life, universal life, and indexed universal life.

Whole life insurance is more expensive because you're not only paying for insurance, but you're also paying for the investment portion. In almost every single scenario, the amount you pay into a whole life insurance policy will never equate to the benefit you receive. No matter how much the investment portion grows, the insurance company will still take their fees. As such, it's almost always better to keep life insurance as term insurance, and invest the other money in the stock market.

The Life Insurance Math - Why Term Life Insurance Is Better

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 (this, of course, varies based on a lot of factors, but it s good estimate).

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 this is insurance and not simply an 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.

This works out in almost every single scenario. Where does that extra money go? Into the pockets of the life insurance company or their salesmen as a commission.

A Look At What Really Bad Whole Life Looks Like

Of course, some policies are worse than others. And we love showing math, so we wanted to share what a really bad whole like policy looks like.

This policy is from a major company in the space. It was issued in 6/2012 and this reader shared his story with us about 7 years into the policy. The reader is 40, male, healthy, and got the policy then at 33, when he was probably even healthier!

It's a guaranteed whole life policy until age 99. It has a current death benefit of $1,551,262, with a current face value of $1,549,562.

The monthly premium is $1,982.72.

This reader has been paying his policy for 79 months - so he's paid a total of $156,634 for this policy.

Guess what thecash value is 7 years later? Just $88,459.

That's almost a -40% return of the past 7 years... (that's negative).

The argument of most insurance agents is "well, you're getting more than life insurance! You're getting an investment as well!"

So, if you want to separate the two - he has $88,459 in "investments/cash value" and paid $68,175 for a $1,500,000 insurance policy.

Any way you slice this it's bad. If you wanted to get a $1.5 million term life policy, this reader would probably pay about $115/mo in a worst case. So, in the same 79 months he's had the policy, he could have had the same insurance coverage for just $9,085. That's a $59,090 difference!

I'm also assuming that he got a 0% return on his investments - because if you start changing the math on the life insurance portion, the return goes negative quickly!

And remember, we're talking about the stock market from 2012 to 2019 - on of the longest bull markets in history! And a 0% return at best (likely negative though). I just shake my head here.

Related: What Is MPI and Universal Indexed Life Insurance?

What You Need To Know About Whole Life Insurance

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. Our friend Todd at Financial Mentor wrote an amazing guide to try to highlight the complexities of whole life insurance. Its 10,000 words long (because whole life is so complex), and it basically sums up why whole life is a bad deal.

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.

Third, if you don't pay in enough to build up a cash value, or you simply stop making payments on your whole policy, the policy could lapse and you lose all your "investment". That doesn't happen with traditional investing. 

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.

Conclusion - Only Purchase Term Life Insurance

The bottom line is that, for young adults, term life insurance makes the most financial sense. The purpose of insurance is to be a backstop against major financial loss in the case of an unexpected event - death. It's not an investment vehicle. It's not sexy. It's not a retirement savings account. No matter how you paint it, insurance is designed to be insurance.

Want to see how affordable term life insurance is? Check out a free quote from Ladder. It's quick, free, and you can help make sure your family is protected.

Or, see our list of the best online term life insurance companies.

Readers, what are your thoughts on the term vs. whole life insurance debate?