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While there are several types of life insurance, the most commonly purchased types of policy are whole and term life insurance. The primary differences between the two policies are the cost, the duration of coverage, and that whole life insurance includes a cash value component.
Given the high cost of whole life insurance, often several times that of term, and product complexity, our analysis shows term is typically better for the majority of people as you can still get significant financial coverage for your family. Whole life insurance is primarily a consideration if you’re looking to combine coverage with an investment vehicle.
- What is Term Life Insurance?
- What is Whole Life Insurance?
- Differences Between Term and Whole Life Insurance
- Should You Buy Term or Whole Life Insurance?
What is Term Life Insurance
Term life insurance is a policy that offers coverage for a specified period of time, the term, and should you pass away during that term, a payout is made to the policy’s beneficiary. The benefit of term life insurance policies is that they can be structured to fit your financial situation, as you can customize several features of the policy:
- Value of the death benefit: Typically available in increments of $50,000, and can go as high as $10 million, depending on your insurer.
- Term length: Policies can often last for 1, 5, 10, 15, 20, 25 or 30 years.
- Level or decreasing death benefit: Level term policies maintain the same payout for the life of the policy. Decreasing term policies pay less money over time.
- Whether the policy is renewable: If you renew a policy at the end of the term, the premium will increase as you’re older, but you don’t need to re-qualify for coverage.
- Riders: These are policy add-ons that typically will increase your premium, but offer additional ways to tailor the coverage to your needs.
That each of these features of a policy is customizable means that term life insurance can be applicable to a wide range of financial scenarios. For example, a new parent that primarily wants to make sure their child will be able to afford college may choose to go with a 20 year level term policy with $200,000 in coverage (as the all-in cost for students to attend a four-year nonprofit college is about $50,000 per year). On the other hand, if you’ve just purchased a home with your spouse, you might consider a decreasing term policy (since your mortgage balance decreases over time as you pay it off) with a death benefit equal to the size of your outstanding loan.
What is Whole Life Insurance?
Whole life is a type of permanent insurance policy, meaning that coverage extends for your entire lifetime so long as you continue to pay the premiums. The features of a whole life policy are the:
- Death benefit
- Cash value
The death benefit of a whole life insurance policy stays the same for the life of the policy, unless you purchase additional coverage, and often ranges from $50,000 to several million dollars (similar to level term). A smaller death benefit is typical if you are looking to cover all costs associated with your passing, such as a funeral and potential hospital expenses. However, if you are your family’s primary earner, have multiple children to send to college, or a large mortgage balance, you may need a larger death benefit to ensure your family can cover all their obligations without your income.
Premiums for whole life insurance are consistent, though they can either be paid annually or for a predetermined period of time (such as 20 years), though they’ll be significantly higher for that period. For example, if you currently have a high income, you might want to pay higher premiums for several years to lock in coverage and reduce your risk.
A primary reason whole life insurance is more expensive than term is because of its cash value. The cash value is essentially what you would get if you decided to give up coverage and surrendered the policy to your insurer. With whole life insurance, the policy’s cash value is guaranteed to grow at a certain rate each year and you can:
- Use it to pay premiums
- Purchase additional coverage with it
- Take out a loan, using the cash value as collateral
- Withdraw the money, in certain cases
In the event you pass, the cash value is not paid to your beneficiary like the death benefit would be. So, if you had a $250,000 whole life policy in place for 10 years and the cash value was $25,000, in the event an emergency came up you may be able to borrow up to $25,000 from the insurer. However, if you died soon thereafter, your beneficiary would receive $225,000 (the death benefit of the policy minus the value of the outstanding loan).
Not all whole life insurance policies pay dividends, and this option is typically available at mutual insurers (since the company’s owners are its policyholders). The way it works is that, each year, the insurer deduct all expenses, such as death benefits paid and the costs of running the business, from the money they’ve made (premiums collected, investments, and any other sources of income) and pays out any net profit as a dividend. To illustrate, say an insurer had $1 million of income in a year, but death benefit payouts and expenses only came to $900,000. If they had 10,000 policyholders receiving dividends, each would get $10 as a dividend.
While dividend paying whole life policies aren’t actually guaranteed to pay a dividend, should they do so, you don’t have to pay income tax on the money as it’s considered a return of premium.
Differences Between Term and Whole Life Insurance
To summarize, here are the key coverage differences between term and whole life insurance policies:
|Policy Feature||Term Life Insurance||Whole Life Insurance|
|Death Benefit||Can be level or decreasing, wide range of options||Level, wide range of options|
|Premium||Level for entire term, can be paid monthly or annually||Level, can be paid for length of policy or shorter period|
|Period of Coverage||Specified term, from 1 year to 30+ years||Lifelong|
|Cash Value||Term has no cash value and can’t be borrowed against||Cash value has guaranteed, tax-deferred growth|
|Dividends||Not eligible||Eligible if available through insurer|
Aside from the policy features, the biggest difference between term and whole life insurance policies is the cost. Due to the lifetime coverage and cash value, whole life insurance costs considerably more, meaning it can easily come to 10 times the cost of a term policy with the same death benefit. This means whole life insurance can be prohibitively expensive for many and particularly so for those that need life insurance as financial protection.
A common piece of advice is to “buy term and invest the difference.” It sounds simplistic, but say you had the choice between a 20-year term policy that cost $200 per year term and a $1,000 per year whole policy. If you purchased the term policy and each year invested the $800 savings, at the end of the 20 years you would have $27,775 (assuming a modest 5% annual rate of return on your investment).
Should You Buy Term or Whole Life Insurance?
This question is dependent on your financial situation but, when deciding between term and whole life insurance, you should consider the following questions:
How long do you need coverage? If you’re getting insurance in order to make sure your family can cover key expenses that won’t be applicable after a certain period of time, like your child’s college or your mortgage, a term policy is likely a better fit. And if you have sufficient retirement savings in place, you may only need term coverage until your planned retirement age. But if you want coverage for end-of-life expenses, such as a funeral or to pay off student loans, or to supplement your income (assuming your family doesn’t have the savings to do without it), you may want the permanent insurance coverage that whole life gets you.
Do you just want coverage, or a supplement to your investment portfolio and estate planning? Unless you want a small death benefit to cover final expenses, the cost of whole life insurance makes it a poor choice for simple coverage. You would need to take advantage of the cash value of the policy or have it as a part of your estate plan in order for the investment to make sense. For example, a young, high-income parent may get whole life insurance since they would have lower annual premiums by purchasing early when they’re healthy. Over decades the cash value would grow, meaning that money could be used to pay off higher interest loans. And when the parent dies, the death benefit would help to cover any estate or inheritance taxes faced by their child.
Convertible Term Life Insurance
If you want to get life insurance coverage immediately, but can’t decide between term or whole, you don’t have to. Convertible term life insurance is simply a term policy that can be converted to a whole policy at any point during a specified period of time (typically several years) without you having to undergo a new health assessment. Should you choose to convert to a whole life policy, your premiums will increase and the death benefit of the policy will remain the same.
The options to convert a term policy can be incredibly valuable if, for example, you’re young and on a potentially high-earning career path. You may not be able to afford the higher premiums early in your career, but have dependents that would be impacted if you passed. Later on, if you do particularly well in your professional life, you can convert the policy to take advantage of the cash value benefits.