Life insurance can be used as a vehicle to fulfill your financial goals by protecting and providing financial security for your family and protecting your estate; in some cases, it can also function as a tax-free retirement account.
There are two primary types of life insurance: whole and term. Both have different features and benefits that could work for you, depending on what you would like your policy to do.
What Is Term Life Insurance and How Does It Work?
Term life insurance is simple: it pays out to your beneficiary upon your death, providing a death benefit for a specified set of years that ranges from 1 to 30 years. Term life is short term and typically the most affordable type of life insurance. Your death benefit could help your family financially cope upon your death.
When choosing which term and death benefit you want, consider how much debt you have left to pay off or a situation you’d like to cover in case you pass. For example, if you have a car loan that lasts for eight years, a 10-year term life policy could ensure that it is accounted for in the event of your passing before you have finished paying off the loan. Or, if you want to support your child’s college tuition but they have 4 years of schooling left before enrolling in college, a 5-year term life policy may be a good option. If you die within this 5-year term and before your child enrolls into college, the death benefit will pay to your beneficiary and they may still use it for tuition.
Term life insurance is also known as “pure life insurance” because unlike whole life policies, term life policies do not build any cash value within the policy.
Types of Term Life Insurance
There are different kinds of term life policies that may be suitable for your situation and goals.
- Level Term Policies: This policy will cover you for a set amount of time with a locked-in premium and death benefit that doesn’t go up or down. If your ultimate goal is to leave something behind to help your family when you die, this policy could be beneficial. It is important to note that if you outlive the term you signed up for, the policy will not pay out.
- Convertible Term Policies: This policy starts as a term life, but you can convert it into a whole life policy in the future. When you apply for a new whole life insurance policy, companies typically look at your age and health, which can introduce obstacles for eligibility. When you decide to convert your existing term policy, however, you will likely not be subject to health or medical questions for eligibility.
- Decreasing Term Policies: This policy’s death benefit declines over time. Because of this decline, this type of policy can be more affordable and flexible compared to the other term life options. If you have debt, such as a 20-year mortgage, you could get a decreasing term policy that matches your mortgage in case you unexpectedly die. This could allow your family members to pay off the mortgage without as much financial burden.
- Return of Premium Policies: This policy is more expensive than other term life policies, but could be beneficial if you’re unsure about whether you will outlive your term. In the case that you exceed your term, this type of policy pays you back for all of the premiums that you had paid into the policy.
- Yearly Renewable Term (YRT) Policies: This policy allows you to renew your coverage every year. This type of short-term term life can be beneficial for temporary situations, such as if you are in between jobs but expect to get life insurance coverage through your next employer.
What Is Whole Life Insurance and How Does It Work?
Whole life, also known as permanent life, is long term and like the name suggests, will last for your entire life. Whole life policies provide a death benefit that builds cash value and that can be used for your or your family’s future needs.
Premiums for whole life policy holders will stay level, meaning it will never go up as you get older. When you pay your premiums on this type of policy, the money will be split 2 ways: part of your money will go to the death benefit and the second part will go into building your policy’s cash value. This acts like a savings account which grows with tax-deferred interest.
Some policies may allow you to make a withdrawal, take out a loan, or use the cash value to pay for your future insurance premiums once you have built up your policy’s cash value enough.
Types of Whole Life Insurance
There are two types of whole life. The first type is what we call a traditional whole life, in which you pay premiums in exchange for a death benefit. The second type of whole life insurance is interest-sensitive whole life. In these policies, the cash value that accumulates is tax deferred and performs alongside the market with a guaranteed interest rate.
Traditional
- Non-participating: In the case that your insurance company performs well in the market, you won’t be able to receive dividends from them.
- Participating: In the case that your insurance company performs well in the market, you will be able to receive dividends from them.
- Indeterminate Premium: With this specific type of whole life policy, the premiums for your whole life insurance can change at any time. However, there is a maximum premium that cannot be exceeded.
- Economic: Your death benefit with this policy can either grow or decrease over the years, depending on how well your insurance company does financially in a year. You could receive dividends, and with these, you could add on a term life policy to potentially increase your death benefit.
- Limited Payment: This policy is a set premium you have to pay for 10 to 20 years. After that, you will not have to make premium payments anymore because your life insurance is paid up.
- Single Premium: This policy is a one-time payment for your whole life insurance, so you won’t have to make any payments on it in the future.
Interest-Sensitive
- Universal: Universal life is flexible, allowing you to change your death benefit and premiums at any time. The cash value that is accumulated grows alongside the index, such as the S&P 500. When the S&P 500 drops, your cash value stays the same. When the S&P 500 grows, your cash value will also grow at a guaranteed interest rate.
- Current Assumption: Your premiums can either go up and down with this policy. Premium rates will be affected by the interest rates in the market, your insurance company’s mortality rate, and their financial investments.
- Excess Interest: Your death benefit and premiums are set. Any excess interest will be put into the cash value.
- Single Premium: This policy is a one-time payment for your interest-sensitive life insurance, so you won’t have to make any payments on it in the future.
Fixed-dollar vs. Variable Options
In addition to traditional or interest sensitive policies, whole life policies can also be categorized by whether the premiums are fixed dollar or variable. A “fixed-dollar” whole life policy means that your premiums will stay the same every year regardless of your age or health. The fixed-dollar option is beneficial for those who are looking for a standard permanent life insurance. Many traditional whole life policies are fixed-dollar.
The variable option will fluctuate your cash value because it’s put into investment options such as stocks and mutual funds. For those who are looking for other investment options or a tax-free retirement account option, this could be a good choice. It’s important to keep in mind that because your cash value is directly connected to the market, the premiums will likely be higher. The majority of interest-sensitive life policies are variable.
Term vs. Whole Life Insurance Feature Comparison
The length of coverage and premiums are some of the biggest differences between term and whole life insurance. Let’s take a look at the different features that term and whole life have.
| Feature | Term Life | Whole Life |
|---|---|---|
| Guaranteed death benefit | Yes, but only if the policyholder dies during the policy term period | Yes |
| Coverage length | Set period, typically between 5 and 30 years | Lifetime coverage |
| Living benefits | None | Borrowing against cash value or withdrawing cash value for use whole alive, depending on policy |
| Cash value | No | Yes, in most cases |
| Cost | More affordable, but more costly over time with each renewal | More expensive, but no renewals and no premium increases over time |
Term vs. Whole Life Insurance Cost Comparison
Whole life is more expensive than term life because it lasts until you die and accumulates cash value. Below is an example of monthly average costs between term and whole life for a male and female non-smoker at different ages looking for a $100,000 policy. However, keep in mind that unlike whole life policies, term life policies would renew at the end of the term at a higher price, making it a more costly option in the long run.
| Policyholder | Death Benefit | 20-Year Term | 30-Year Term | Whole Life |
|---|---|---|---|---|
| Male, 30 years old | $100,000 | $18.16 | $22.15 | $86.29 |
| Female, 30 years old | $100,000 | $13.53 | $17.21 | $76.29 |
| Male, 40 years old | $100,000 | $26.79 | $33.15 | $122.29 |
| Female, 40 years old | $100,000 | $21.45 | $25.25 | $107.29 |
| Male, 50 years old | $100,000 | $55.45 | $62.08 | $188.29 |
| Female, 50 years old | $100,000 | $40.23 | $70.18 | $164.29 |
Term vs. Whole Life Insurance Pros and Cons
Term Life Insurance Pros
- Budget-friendly: Term life offers affordable premiums with larger death benefits without putting a dent in your finances.
- Can convert to a whole life policy at any time: If you’re still unsure about getting something permanent, you can always convert your term life policy into a whole life policy in the future.
- Flexible: You can decide how long you want your life insurance coverage to last.
Term Life Insurance Cons
- No cash value: There’s no cash built up.
- Coverage will expire: After your coverage ends, you have to find another life insurance policy. You don’t get any of the premiums you paid into your term life policy back.
- Premiums will increase after coverage expires: Your premiums are based on your age and health at the time of getting a policy. It will typically be more expensive finding coverage after your policy expires.
Whole Life Insurance Pros
- Lifetime coverage: You don’t have to worry about your life insurance ending, as your whole life insurance is permanent.
- Accumulates cash value that you can withdraw and loan from: Whole life can act as a secondary savings account because it accumulates cash value.
- Budget-friendly with level premiums: With level premiums, you already know what your monthly expenses are going to be and you’re prepared for them. Even as you age or your health declines, your premiums will never go up.
- Cash value grows tax-deferred: As your cash value grows, you don’t have to worry about paying taxes on them until you withdraw those funds.
Whole Life Insurance Cons
- Higher premiums: Whole life is more expensive than term life because it lasts your entire lifetime and accumulates cash value.
- Lack of investment control: You can’t control how your cash value is going to do because it is market-driven.
- Cash value doesn’t accumulate quickly: Your cash value only accumulates when premiums are paid. Depending on how much your premiums are each month, it will take time to see growth.
Choosing Between Term vs Whole Life Insurance
When choosing between a term or whole life, everyone’s needs are different, but there are certain things you can consider to make the best choice for you.
Term life insurance could be best for you if:
- You want to cover a short-term situation, such as job loss or a mortgage
- You want more affordable coverage
- You are not sure if you want permanent life insurance yet
Whole life insurance could be best for you if:
- You are looking for another investment vehicle
- You want to leave a legacy behind for your beneficiaries
- You want to build cash value and withdraw from it in the future
- You are subject to estate taxes
If you’re still unsure on which type of life insurance to get, a licensed life insurance agent or financial expert can help you decide.