As we build healthy, happy families, few of us enjoy grappling with uncertainty, especially the prospect of our own accidental passing. It’s a hard topic to talk (or even think) about, but preparing for the unexpected with life insurance is important. This guide aims to take away the confusion and anxiety on this subject to help you understand two common types of life insurance: term life and whole life.
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We will clarify the differences and get you on your way to making an informed decision. The reasonable upfront costs and long-term benefits of life insurance may surprise you, as there are several options to fit different needs, lifestyles, and ages. We’ll review the importance of life insurance and outline the differences between term life and whole life so you can determine the best choice for you and your family.
First off, why do I even need life insurance?
If you’re a spouse, parent or legal guardian of young children or aging parents, others probably depend on your financial support. Life insurance can help them through the transitional period after you pass away, but it can do so much more. Unless you’ve managed to save a substantial sum, life insurance offers a guarantee that your dependents will be financially compensated in the absence of your income.
Despite that, only about half of consumers cited replacing lost income as a role of life insurance in a survey by Prudential. That’s striking — and perhaps frightening— since the average working household has just $2,500 in retirement savings, according to a study by The National Institute on Retirement Security.
Buying life insurance is easy, and it’s a practical first step towards your family’s financial independence should they be faced with life without you.
What is the value of permanent life insurance coverage?
Permanent life insurance is life insurance designed to help you build wealth and protect your family and assets over the course of a lifetime — hence the “permanent” name. It also has the ability to accumulate cash value on a tax-deferred basis.
Two key features that you must be aware for permanent life insurance is that they can build cash value over time, as well as provide a death benefit to your beneficiaries.
Cash value accumulates from funds used to pay premiums. The money is invested into the company’s general account — the company then invests those funds in investments, typically corporate bonds and equities —which generate a return based on performance, as with standard types of investments. Cash value can accrue tax-deferred offering the dual benefit of protection and savings.
Dividends generated by the underlying investments can be reinvested, increasing the policy’s death benefit and cash value. Typically, any withdrawals made against the cash value would constitute a loan and if not repaid, would reduce the policy’s overall death benefit.
Access to cash value is such an attractive feature because it’s one way to plan for larger expenses, such as a mortgage, college costs or other debt. But keep in mind that taking money out of the account during your lifetime can reduce the face value death benefit paid to beneficiaries, or have other negative effects on the policy. However, the money taken from the cash value can be placed back into the account — and might be mandatory depending on the type of insurance policy.
Although, having access to cash value may be appealing, there is risk associated with permanent insurance. Premiums are higher, which do not account for interruptions in income, and fixed premiums could go up after a cash value withdrawal to retain the policy’s face value.
Bottom line: “Permanent insurance” is really a catchall phrase for a wide variety of life insurance products that contain the cash-value feature. Within this class of life insurance, there are a variety of different products like whole and universal insurance, explained more below:
What’s the difference between whole and universal life insurance?
Whole and universal life are both a type of permanent life insurance which accumulates cash value. The difference lies in how that cash value accumulates and how each policy’s pricing is structured.
With whole life insurance, you pay a set premium which covers the insurance cost and adds to the policy’s cash value.
With universal life, the insurance company sets the minimum insurance cost and anything you pay in addition to that amount is applied to the policy’s cash value. This offers more flexibility in building cash value over time.
With both policies, you have the ability to borrow against the accumulated cash value during your lifetime. A loan can accrue interest and if it’s not repaid, that can affect the face value of the policy, and the associated death benefit paid to your beneficiaries.
Here are more distinctions to consider:
Whole life insurance:
- Has a fixed premium that never increases with a guaranteed death benefit. Premiums can be paid monthly, quarterly, semi-annually, or annually.
- Payments can be temporarily stopped at the client’s request as long as the policy has accumulated sufficient cash value to cover premium costs during the requested term. This, however, has an impact on the death benefit. Funds can be borrowed, but they must be paid back with interest or the policy could lapse.
Universal life insurance:
- Premiums are adjustable, and payments can be suspended. However, this will reduce the face value of the policy.
- Policyholders can elect to decrease the death benefit to lower premiums or increase it if their needs change (upon successful completion of a medical examination).
- Funds can be taken out of the account and never replaced, but this reduces the face value. Once you accumulate sufficient cash value in the policy, you can use it cover the associated premiums.
- Alternately, you can surrender the policy and withdraw any accumulated cash value. This, however, may trigger a surrender charge for cancelling the policy.
- The set nature of the interest rate is also something to consider. A higher rate can allow for relatively easy cash growth. A lower rate, by comparison, can strain the policy’s ability to accumulate cash value. Essentially, you may have to pay more into the policy to get the target cash value or death benefit you desire
Who should buy whole life insurance?
Whole life is a type of permanent insurance that offers a fixed monthly premium and death benefit. (Reminder: A death benefit is the amount paid to a beneficiary upon the death of an insured person.)
This offers the peace of mind that the premium and coverage will never change and guaranteed cash value accumulation, which may be most suitable for individuals with other forms of assets seeking an alternative long-term, low-risk diversification strategy.
Whole life insurance may be suitable if you want:
- Long-term planning: Additional riders that help plan for disabilities, long-term care, retirement and more can be added to the policy. (Riders are like add-on’s to your policy that can provide additional benefits.)
- Lifetime protection: Coverage can be purchased for a specific period and extended for as long as the policyholder lives.
- A consistent premium: The premium never changes, but it’s higher than term life insurance.
- Protection combined with savings: Guaranteed death benefit combined with accumulated cash value and accrued interest that grows tax-deferred.
- Access to cash value: Cash value can be taken out of the account and used to pay for unexpected expenses.
What is the value of term life insurance coverage?
Unlike permanent life insurance, term life insurance covers an individual for a certain length of term, i.e., the “term.” If the policyholder dies during the term of the policy, their beneficiary will receive the guaranteed death benefit.
A term may last for 5, 10, 20, 25, up to 30 years. This type of policy is designed to help participants plan for the unexpected if it should occur during the term.
It does not accumulate cash value and is the most affordable plan option. Like with permanent insurance, living benefit riders can also be added to term life policies.
Who should buy term (temporary) life insurance?
Term life insurance is a low-cost plan designed for anyone who wants the peace of mind that their beneficiaries are protected while keeping down the cost. Here are other reasons people buy term life insurance:
- Families with young children: Protect family while children are still at home and need the most financial support.
- Homeowners: A term policy can help beneficiaries cover mortgage expenses if you die before your home is paid off.
- Unmarried with no dependents: Single adults may want to purchase coverage for themselves to help their family settle their affairs and cover burial expenses.
- Aging adults: Term life insurance may be suitable if you’d like to leave your spouse or children money to cover funeral or burial expenses. Just remember that term life premiums generally become more expensive as you grow older.
- Second mortgage: Chances are that if you’ve taken out a second mortgage to supplement your income, you don’t have a lot of savings. Term insurance can help repay the debt and keep your family in the home if you were to pass away during the term.
If you want more information on the ins- and outs- of term life insurance, check out this guide: What Is Term Life Insurance?
Comparing term vs. whole life coverage
They both pay when you pass away, but that’s pretty much where the similarities end. Let’s cut through the confusion with a side-by-side comparison.
What are my options at the end of my term period?
At the end of your policy’s term you have two options. You can keep the policy and pay higher premiums, which are outlined in the policy’s rate table and increase annually as you age, or you can convert it to a permanent life policy — but there’s a catch.
The conversion must be completed while the term is in effect. This will also help to avoid a medical exam. Some insurance providers have cut-off limits that state once policyholders pass a certain age limit the policy cannot be converted. If a policy lapses or is not converted on time it can be replaced with a new policy at one’s current age and health, which will likely result in higher monthly premiums.
There is one thing to keep in mind, however. Some life insurance companies do not allow conversions of term life policies to permanent insurance coverage. If this is something you may want to pursue at a future date, you’d need to be sure that a conversion is possible when you initially purchase term life insurance.
Should you buy both whole life and term life insurance?
There are times when it makes sense to buy both whole life and term life insurance coverage:
- Need coverage but can’t afford high premium: If you have whole life but need more coverage and want to keep the expense low.
- Growing your family: Having kids or buying a larger home can create the need for more coverage.
- Need more coverage for the short-term: If you have a whole life policy but want to use term life to cover major expenses like a mortgage or college.
- Employer-provided coverage: Employer provided policies often have gaps in coverage.
- Increase of income: When you have a term policy and can now afford whole life insurance.
Is my employer-provided insurance enough?
Most Group Life Insurance coverage is calculated based on a multiple of your income. Generally, coverage is $50,000 to $100,000. This amount is relatively low and it may not adequately replace your income. For example, we recommend having enough coverage to equal 3-7x your income.
Use this insurance calculator to better estimate your needs. If you discover a gap in coverage, consider supplementing your group’s policy by purchasing a separate individual term or whole life insurance policy.
How do I know which policy is right for me?
Now that you know how life insurance works and what types are available, you may be wondering which policy and how much coverage is right for you. The Prudential survey also revealed that respondents felt that having $250,000 in coverage was an exorbitant amount and said they only needed 2-3x their income.
This is not always the case. To properly calculate your coverage needs, tally your household’s annual living expenses for the next 10, 15, or 20 years. Then add 3 percent per year to adjust for inflation. Consider factoring in other expenses, such as the cost of college tuition, mortgage and other debts. This is the amount of coverage you need, even if you participate in an employer-sponsored group life insurance program.
After you have calculated your need, compare it to how much you can afford. Can you handle the higher cost of whole life insurance or is term life insurance suitable for now? Four out of five people incorrectly assume a high face value means expensive premiums, according to Life Happens and LIMRA, an association of insurance and financial services companies.
Whether permanent or term life, it’s imperative to keep adequate coverage. You can start with temporary life and always upgrade to a permanent policy in the future.
When is the best time to buy term life insurance?
Purchasing term life insurance at the right time can help lower the premium while providing optimal coverage and protection for yourself and your family. There are a few key considerations:
- You’re young: The younger you are, the cheaper term life insurance is. Rates increase as you get older.
- You’re healthy: A clean bill of health is another major factor that influences your insurance rate.
- You’re starting a family: Attending to the needs of your bundle of joy should be the only thing keeping you awake at 3 a.m.
- You’ve begun acquiring assets: Use term coverage as an estate planning tool to protect your assets as you build wealth.
- You’re (only) human: Although we don’t like to think about it, unexpected death happens.
Bottom line about life insurance
Purchasing life insurance is an important decision and a lot of factors must be taken into consideration. However, remember you’re not alone. Feel free to talk with one of our Financial Guides here brightpeak. Just call 888.362.5502 (toll-free), or click on our chat feature. They can answer your questions and help evaluate your goals to ensure your policy is the right fit. This way you can focus on protecting your most valuable assets — you and your family.
Review your term or whole life insurance policy with a financial advisor at least every few years. As family life events, such as marriage, a birth, and changes to your income or net worth occur, reconsider your policy’s coverage amounts and protections and make adjustments as often as necessary.